Asset Backed Securities – A private credit strategy whose time has come

By Pratik Joshi, Portfolio Manager

At a glance

Not all securitisation structures are same

Asset Backed Securities (ABS) is an umbrella term used for securities backed by financial assets such as interest-bearing receivables or loans (secured or unsecured) in most instances and supported by bankruptcy remote non-recourse structures. Residential Mortgage-Backed Securities (RMBS) refer to securities backed by first ranking residential mortgages and ABS when backed by loans and leases extended to individual consumer / commercial entities for autos, equipment, credit cards, and unsecured personal loans among others. For the purposes of this discussion, RMBS falls within the broader umbrella of ABS.

Securitisation refers to the process of pooling the abovementioned financial assets to create ABS/RMBS notes or bonds and in the process convert illiquid loans with idiosyncratic risk into relatively liquid securities, secured by a pool of granular assets (thereby mitigating idiosyncratic risk associated with individual loans). This allows matching the return requirements of the investors with the corresponding risks (and structural mitigants) across various tranches of these securitised structures.

Unfortunately, the only introduction to securitisation for those unfamiliar with securitisation often stems from the infamous sub-prime mortgage crisis in the US during the Global Financial Crisis (GFC) in 2008. Media articles and popular culture portrayals like the film “The Big Short,” have painted securitisation with a broad and negative brush. However, for individuals other than market participants actively engaged in securitisation both before and after the GFC, it is not easy to distinguish between the conservative securitisation structuring established since the early 20th century which continues to be a bedrock of the global financial industry and the highly risky derivative products that emerged and gained notoriety during the GFC, such as collateralised debt obligations squared (CDO-squared) among others.

As a starting point for investors, it is important to distinguish between the two to better understand the risk-return characteristics of a well-structured Australian / New Zealand ABS investment. The derivatives have been talked about enough in the public references above and we have nothing more to add as we don’t invest in those. However, this paper does aim to delineate the investment philosophy of Revolution Asset Management (Revolution) when investing in ABS / RMBS ― based on a deep understanding of the market, credit expertise, long standing experience, and a rigorous due diligence process.

The ABS investment landscape

The principles of securitisation have been used across many geographies to issue ABS either in the public market or through private placement / private warehouse financing. The annual public market issuance of Australian ABS stood at ~AU$52 billion in 2023. Public ABS issuance within the first quarter of 2024 has crossed AU$18 billion. However, the private market warehouse financing is several multiples of that (estimated to be ~AU$150-200 billion and growing rapidly) and provides a strong funding source to the non-bank sector which primarily relies on the securitisation market for its funding.

Australia is one of the largest markets for securitisation issuance due to its strong regulatory framework. Its laws enable the recovery of the last dollar owed by the borrower, a distinct advantage compared to jurisdictions like the USA, where reliance solely on the recovery from underlying security is common.

Key features of the public ABS market

Key features of the public ABS market include:

• Static pool of loans which means the loan pool composition remains the same through the life of the deal
• Public credit ratings from rating agencies
• Monthly reporting and associated limited triggers to the cashflow waterfall which primarily benefits the AAA rated note holders in terms of seniority to receive interest and principal by the legal final maturity (usually equivalent to sunset date).

A consequence of static pools is the dependence on the vintages of the loans originated which could sometimes have an adverse effect on the performance of the deal. For instance, non-conforming RMBS deals with mortgages primarily originated in 2020 and 2021 when valuations were at historical highs could come under pressure due to debt / repayment serviceability of the borrowers that were tested at interest rates lower than the variable rates post the recent interest rate hiking cycle.

Revolution’s investment expertise and experience skews heavily towards private ABS investments over public ABS due to several factors including lack of sufficient size of tranches and risk adjusted margins generally being between 2-3% tighter on these public ABS notes when compared to similar tranches of the private ABS warehouses for same or comparable originator and underlying loan assets. Investment horizon of these notes could widely vary from expectations due to prepayment / extension risk and so would its value based on the negative convexity of these notes.

Revolution focusses on investing in the mezzanine notes of private warehouses for the same issuers which eventually term out the receivables / loans from these warehouses into the public market ABS deals referred above. These warehouse investments offer specific advantages that are highly aligned with the ABS investment philosophy of Revolution.

Key benefits of private ABS and Revolution’s Investment Philosophy for these investments

1. Ability to negotiate the eligibility criteria of the loans that can be part of the pool which secures the interests of the note holders such as Revolution. A good example is that Revolution has been able to ensure that its investment in mortgage warehouse pools have no exposure to construction / development risk or to any recently built high rise apartments. Revolution has stayed away and highly restricted the composition of ABS pools with insufficient borrower loan serviceability requirements, especially for the loans not regulated under the National Consumer Credit Protection Act of responsible lending.

2. Ability to negotiate the pool parameters that ensures that the quality of the revolving pool is in line with the credit expectation (expected default rate, default timing, recovery rate, recovery timing, yield on loans, borrower / security / loan credit quality) on which the deal has been structured at initiation. This is critical since a revolving pool allows selling new loans to the pool on a monthly or more frequent basis, unlike the static pool of most public deals described above.

3. Ability to initially negotiate and modify over the life of the revolving period, the various triggers for delinquencies / arrears, loss rates / charge-offs among others. The consequences for these triggers being stoppage of funding and initiation of amortisation of these warehouses. These warehouse financing vehicles are lifelines of non-bank originators with securitisation representing close to 85% of funding composition for these originators. Hence, these originators are highly motivated to work with note holders such as Revolution to ensure that stop funding events or amortisation events are not triggered for these warehouses. This allows for the opportunity to work through any difficult situation of worsening delinquencies and loss levels for loan pools. Revolution monitors monthly servicer and trust manager reports in detail for all its investments which plays a key role in identifying early warning signs of deterioration in credit quality and ability to initiate a path to remediation with originator well ahead of the breach of triggers.

4. Private ABS warehouses generally have higher credit enhancement levels and lower advance rates compared to the equivalent tranches of public ABS deals due to the revolving nature of the pools. This allows for better cover against losses for similar risk as well as larger note sizes which compensates investors for the intensive due diligence required to invest in these notes. Public market term outs of these warehouse pools automatically refresh the vintage of the loans making it more representative of the current macroeconomic and lending environment.

5. Private ABS warehouse tranches have a clear and observable illiquidity premium when compared to the equivalent respective tranches of public term deals. Over time this illiquidity premium has ranged from 2.0% to 3.5%. These private tranches are generally 2 to 3 years revolving maturities which are rolled at Revolution’s option based on continued satisfactory performance. Revolution only invests in warehouses of well capitalised originators backed by reputable sponsors in relatively vanilla asset classes such as residential mortgages, auto loans, equipment loans, credit cards, personal loans, such that there are enough replacement servicers that can cover for the worst-case scenario of servicer default.

6. The floating rate nature of these notes ensure that there is no interest rate risk which has been important lately in the steepest interest rate rise cycle in history where the Reserve Bank of Australia hiked interest rates by 425 basis points.

7. Most importantly, warehouse financing structures are less sensitive to market timing which allows Revolution time for detailed due diligence and the ability to work through all of the above parameters. This allows the opportunity to make a very high conviction call and long-term commitment to be stable and an anchor partner for the selected originators.

Overall, the ABS relative return potential remains particularly compelling, as well-capitalised lenders with conservative underwriting polices and strong servicing capabilities will be the winners in the ABS market. Revolution’s investment process specifically targets ABS originators in Australia and New Zealand which are able to withstand economic turbulence and avoids originators with riskier business models.

Important Information

This information is for institutional and professional investors only and has been prepared by Revolution Asset Management Pty Ltd ACN 623 140 607 AFSL 507353 (‘Revolution’) who is the appointed investment manager of the Revolution Private Debt Fund II and the Revolution Wholesale Private Debt Fund II (together ‘the Funds’). Channel Investment Management Limited ACN 163 234 240 AFSL 439007 (‘CIML’) is the Trustee and issuer of units for the Funds. Channel Capital Pty Ltd ACN 162 591 568 AR No. 001274413 (‘Channel’) provides investment infrastructure services to Revolution and Channel and is the holding company of CIML. None of CIML, Channel or Revolution, their officers, or employees make any representations or warranties, express or implied as to the accuracy, reliability or completeness of the information, including forecast information, contained in this document and nothing contained in this document is or shall be relied upon as a promise or representation, whether as to the past or the future. Past performance is not a reliable indication of future performance. All investments contain risk. This information is given in summary form and does not purport to be complete. To the extent that information in this document is considered advice or a recommendation to investors or potential investors in relation to holding, purchasing or selling units in the Funds please note that it does not take into account your particular investment objectives, financial situation or needs. Before acting on any information you should consider the appropriateness of the information having regard to these matters, any relevant offer document and in particular, you should seek independent financial advice. For further information and before investing, please read the relevant Information Memorandum available on request.