Securitization investors seek risk as concerns and deal protections increase
The ongoing pandemic and the resulting weak global economy will lead to tighter-than-expected underwriting of structured transactions and continue to weaken their performance, but investors are nevertheless starting to open their arms to more risk.
Collateral underwriting tightened in first half 2020 in certain consumer asset-backed securities (ABS), residential mortgage-based securities (RMBS) and commercial mortgage-backed securities (CMBS), and will remain tighter through the rest of the year as collateral deteriorates in the ongoing recession, according to Moody’s Investors Service in a July 24 report titled, “H2 2020 Outlook—Underwriting will remain tighter as pandemic’s effects continue to weaken collateral performance.”
Tighter underwriting will reflect “somewhat” raised standards and additional scrutiny of borrowers, such as more rigorous employment verification standards, Moody’s says, adding sponsors may also reduce loans subject subject to forbearance or deferrals, mortgages on hotel or retail properties, and other riskier loans.
In second half 2020, Moody’s says, deals will have higher subordination levels or otherwise be structured more robustly, and collateralized loan obligation (CLO) reinvestment periods will likely be shortened to three years from five years.
Despite increased caution, however, securitization issuance globally has already started to recover from its lows in April and May, when it fell below $20 billion, Moody’s says, adding that volume surpassed $35 billion at the end of June, approaching 2020’s high of $40 billion in March.
And investors are willing to take on more risk. Although investor concerns are still suppressing volumes last year, new securitizations have nevertheless included material amounts of weaker asset types.
“In the second half, global securitization collateral will likely continue to include weaker and esoteric asset types unless stalling economic activity significantly heightens investor concerns, Moody’s says, attributing the ‘reach for yield’ behavior to today’s ultra low interest rates.
The rating agency says the extent of collateral deterioration will depend in part on how long the virus persists and the extent to which local economies recover. It expressed optimism that most economies will resume growth in the second half, even if economic activity remains lower. However, certain asset classes, including US and European CLOs and non-prime/non-conforming consumer-related securitizations may deteriorate further because of their inherently weaker financial strength.
On the commercial-loan front, for example, “We expect the trailing 12-month global corporate speculative-grade default rate to reach 9.35% in December, up from 5.4% at the end of June, which was already the highest in a decade,” Moody’s says.