The number of investors considering investing in asset-backed securities continues to grow. We are often asked to identify the benefits of ABS relative to other asset classes, particularly corporate bonds. The short list of benefits typically includes a pick up in rating, a pick up in spread and most importantly, a pick up in structure. In the event of bankruptcy of the seller, the assets in the SPV are solely for the benefit of the secured noteholders. This is the key to the ABS structure that isolates the event risk' that has plagued the corporate bond market.
The effectiveness of the ABS structure is made obvious with the fact that since the inception of the European ABS market, no European ABS has ever defaulted. Compare this to the corporate market that experienced a 2.3% default rate in 2000, based on the number of issues in a Standard & Poor's default study. Additionally, the stability in ratings exhibited in the European ABS market is enviable relative to the corporate market where downgrade drift is much more prevalent and upgrade drift less so.
The value of structure is made clear by comparing a Fiat Spa (Fiat) corporate transaction and a Fiat ABS. In July 2000, Fiat accessed the capital markets with two distinct offerings: one in the ABS market and the other in the corporate bond market. In the ABS market, the First Italian Auto Transaction 1 (FIAT 1) was a securitisation of auto loans made by Fiat's captive lending company. The deal is euro-denominated and at issue had an average life of 3.85 years. The issue carries triple-A ratings from Moody's, Fitch and S&P. The issue was priced with a coupon of three-month Euribor plus 28 bp.
At roughly the same time, FIAT issued the 6.125% of August 2005, a fixed rate bond that asset swapped to three-month Euribor plus 45 bp. The issue was rated A3 by Moody's. The offered side spreads of the two issues are shown in Exhibit 1. When the transactions were issued, the FIAT 1 was trading tight to the Fiat Aug-05 by roughly 17 bp. As of 20 February 2001, the difference had widened to 63 bp, an increase of 271%.
As the FIAT 1 has tightened since issuance by roughly 4 bp, nearly all the change in the spread differential is the result of the widening on the corporate bond.
The difference in the spread behaviour of the FIAT 1 and the FIAT Aug-05 highlights the fact that corporate bonds tend to be much more sensitive to events affecting an issuer than ABS. Over the past few months, Fiat has faced a number of negative events.
*On Dec. 1, 2000, Fiat announced that it reduced the official prices of passenger cars in the U.K. by up to 13%;
*On Dec. 5, 2000, it was announced that Italian new car sales rose for the month of November 2000 but that Fiat had lost market share;
*The increase in sales was largely due to discounts being offered by the manufacturers to the consumers; and
*On Jan. 16, 2001, Moody's placed the long-term rating of Fiat (A3) on review for possible downgrade.
The corporate bond is very sensitive to events, as seen by the increase in spread volatility following these events. Of equal importance is that there appears to be very little correlation between the spread volatility of the FIAT 1 and these events, affirming that the ABS structure was successful in isolating the FIAT 1 from event risk surrounding the issuer. In fact, the spread movements on the FIAT 1 were mainly the result of supply and demand factors in the European ABS market as opposed to any specific event involving the issuer.
The ABS achieves a pick up in structure and a pick up in ratings (triple-A versus A3), but how has the ABS fared relative to the corporate bond in total return? Shown in Exhibit 2 are monthly and five-month total returns on the two issues.
Over the five-month period, the FIAT 1 has outperformed the corporate bond by almost 300 bp. However, based on the five-month total returns, it would be imprudent to claim that ABS structures always outperform corporate bonds or that this five-month period holds any predictive ability for future periods. This happened to be a period that was full of negative events regarding Fiat's business and hence very detrimental to the return on the corporate bond (aka event risk). What is worth noting is the stability of the returns on the FIAT 1 versus the volatility of returns on the corporate bond.
An important consideration affecting both corporate and ABS transactions is the rate of default of outstanding issues. In the early and mid 1990s, the default rate of corporate bonds averaged less than one percent. However, this trend quickly changed in 1998 with corporate bond defaults increasing each year since then. During this same time period, the credit enhancements along with the legal protection afforded by the SPV allowed the European ABS market to enjoy a default free environment. No European ABS has ever defaulted.
Shown in Exhibit 3 are corporate default rates since 1982 and a least squared line of the data points. The least squared line represents the best fit trend line through the data points which shows that corporate default rates have been rising slightly over the past two decades. Again, compare this to the European ABS default rate that has been nil over the same time period.
Both corporate and ABS issues exhibit robust stability at the triple-A level. In Moody's most recent transition matrix, 95% of all corporate issues and 95% of all European ABS issues rated triple-A were still rated triple-A one year later. However, the two sectors behave quite differently at the lower-rated level. For instance, for single-B rated corporate issues, only 77% were still rated single-B one year later while 7% had been downgraded, 6% had a withdrawn rating, 5% had defaulted and 5% had been upgraded. For European ABS issues rated single-B, one year later 95% were still rated single-B while the other 5% had been upgraded to double-B. No downgrades, no withdrawn ratings and no defaults. This behaviour is very important to investors considering investing in subordinate classes of corporate issues and ABS. Interestingly, Standard & Poor's states, "Since the beginning of 1999, there has been a marked increase in the number of upgrades [in the European ABS market] reflecting the performance of the underlying collateral, testifying to the market's increasing maturity."1
The wild ride in corporate spreads over the past year has resulted in many traditional investors of corporate securities looking to diversify their portfolios with ABS. This decision to crossover is often made simple when the advantages of the product, such as the following, are identified:
*Pick up in ratings by moving into a triple-A rated asset;
*Pick up in yield relative to the rating as ABS issues are offered at level wider than many sovereigns and bank issues;
*Pick up in structure as ABS issues tend to have lower spread volatility and more steady total return profiles;
*No European ABS transaction has ever defaulted; and
*Over the past two years, there has been an increase in the number of up-grades based on collateral performance.
While many investors of corporate securities have endured unexpected events' causing spreads to widen and the accompanying volatile total returns, investors in ABS have experienced a much more stable spread environment and total return profile. That is why we like to say that asset-backed securities offer investors safety in structure.'
1 Standard & Poor's, European Asset-Backed Transactions' Transition Study, Oct. 26, 2000.
