Insurers navigating market volatility are increasingly seeking asset class distinctive yield opportunities, portfolio diversification, and the potential to enhance portfolio quality. Esoteric asset-backed securities (ABS) are an asset class garnering attention that meets these criteria.
Esoteric ABS are very similar to traditional ABS in structure but have the “esoteric” moniker because their collateral may be less familiar to investors. Common collateral in traditional ABS are credit card debt or auto loans. Esoteric ABS may be backed by other types of debt such as consumer loans; leases on shipping containers, railroad cars, construction equipment, or airplanes; digital infrastructure such as data centers, and more.
Benefits to MPL Insurers
Medical professional liability insurers may be interested in esoteric ABS for several reasons, including liquidity, stable credit quality, and additional portfolio diversification.
The esoteric ABS asset class, like other types of ABS, is liquid, a valuable feature for insurers who may need to pay claims quickly. Esoteric ABS also often have shorter maturities than other securities of similar quality, which may help reduce interest-rate risk. And their yields often exceed those other securities—including other ABS—of similar quality and tenor, providing potentially greater income.
Esoteric ABS features structural protections that help ensure their credit ratings will be maintained, if not enhanced, over time. This supports insurers' interests in maintaining portfolio credit quality.
The asset class may also provide additional portfolio diversification given the distinctive nature of the collateral, a valuable aspect in times of greater market volatility.
Changes Since the 2008-2009 Financial Crisis
For some, the term “ABS” is a reminder of a scary economic period: the 2008-2009 financial crisis, when asset-backed securities were among the worst performers. However, factors within the asset class have changed in ways that are beneficial for ABS investors.
When you think of the ABS deals of that era that experienced heavy losses, you probably remember the subprime mortgage crisis, when over-levered consumers with high debt-to-income ratios were granted mortgages that they ultimately couldn’t pay back. However, the esoteric ABS asset class is very different from those products.
That’s because the collateral backing esoteric ABS deals is not mortgage related. In addition, the underwriting process has become more efficient, and lenders today employ much better risk-management policies that govern their investment decisions, which translates to a lower risk profile within their respective credit boxes. Most importantly, the structural protections in esoteric ABS deals issued in the wake of the financial crisis include higher levels of credit enhancement, such as over-collateralization (i.e., more collateral than the deal size itself) and subordination (investors in the highest-rated bonds are paid first, then the next highest, etc.) to help ensure against investor losses.
Levels of credit enhancement at the single-A level across various subsectors more than account for the level of 60-plus day delinquencies currently seen in the market (see Figure 1). Even if all those delinquencies came through as defaults, sufficient credit enhancement is available to enable these tranches to continue to pay principal and interest to investors. Additionally, rating upgrades are common in esoteric ABS, as many deals amortize over time (i.e., the debt is paid off) and build credit enhancement in the process.
Figure 1
Esoteric ABS Credit Support: A-Rated Securities, Various Subsectors
Navigating the Current Market
Today, the current interest rate environment has affected the asset class, but opportunities persist. Performance for esoteric ABS faced challenges in 2022 as the U.S. Federal Reserve embarked on an aggressive campaign to hike interest rates, leading to wider spreads due to increased borrowing costs from issuers.
As a knock-on effect of the Federal Reserve raising interest rates to combat inflation, the front-end of the Treasury curve looks very attractive, in our opinion. Add to that spread for credit risk, and esoteric ABS offers a very attractive entry point and an appealing yield per unit of duration.
There are several factors driving the esoteric ABS market, but two are currently commanding significant attention:
- The Red Sea conflict, where Houthi rebels based in Yemen have attacked shipping, has global ramifications for the shipping industry. Firms are rerouting container vessels around the Horn of Africa, adding 20%-30% to travel time, which is causing shipping rates to reprice significantly higher. This is a challenge for the shipping industry, but it’s great for container lessors that issue ABS deals because operators will need more containers and more container ships to make up for the delay in deliveries. As a result, container utilization and demand will rise, improving the fundamentals of container deals.
- The Aircraft industry is experiencing a shortage of aircraft amid a rebounding business and leisure travel environment. There is a global shortage of aircraft, particularly engines, now that air and passenger traffic is back to pre-pandemic levels. Narrowbody aircraft and engine lease transactions offer solid fundamentals and typically come at very competitive values, which creates optimism around ABS deals in this space.
On the Radar for 2024
For the remainder of 2024, there are two items on the radar that are significantly affecting the esoteric ABS market. They include the evolution of the US consumer and the rise of digital infrastructure and artificial intelligence (AI).
The health of the consumer has been a big topic of conversation during the past 18 months, but it is more nuanced than the US consumer en masse; data show that the prime consumer has been in much better financial condition than the subprime consumer.
The prime, homeowning consumer has enjoyed rising home prices and equity markets as well as an increase in wages. As a result, delinquencies for prime-consumer-related ABS collateral have been well contained.
On the other hand, delinquencies are rising above 2008-2009 levels for subprime auto and unsecured consumer loans as inflation has affected the lower-FICO-score, paycheck-to-paycheck borrowers to a greater extent1. However, the market is approaching an inflection point in delinquencies and can expect better consumer metrics into 2024.
The recent rise in AI has led corporations and individuals to demand greater computing power. This has led to an increase in corporate capital expenditures in digital infrastructure.
As a result, there has been significant growth in digital infrastructure-related ABS in the form of data center and fiber network deals. Data centers offer cashflows backed by the leases on the center’s tenants, which can vary by scale in the form of colocation, wholesale, and hyperscale. As the need for computing power—and more importantly, space—expands, growth and subsequent issuer tiering in this sector will continue to develop.
Should borrowing rates decline at some point this year—a seemingly less-likely event from when the year started—we would expect a good year of issuance in the ABS space and are optimistic about the fundamentals. Through ongoing evolution and adaptation to market conditions, esoteric ABS are poised to play a significant role in institutional investors' portfolios, offering both stability and yield in an ever-changing financial landscape.