A Reach for Risk: Pricing Credit and Liquidity in ABS

Abstract

Spreads in the fixed income market have rallied significantly since spring 2020 based on support from the Federal Reserve and despite weakness in the economic fundamentals. In an environment marked by low all-in yields, tight credit spreads, and slow economic growth, market participants should be searching out lower risk market inefficiencies to pick up yield. This article reviews the primary asset-backed security (ABS) market from October 2020. It finds that liquidity is undervalued as measured by bond/tranche size. There appears to be a continuing overreliance by market participants on intervention by the Federal Reserve to keep order. Small class sizes are also associated with smaller lenders that usually originate fewer loans. These smaller ABS issuers are associated with increased servicer risk. The key recommendation is for investors to buy ABS from larger issuers, deals, and tranches to maximize potential liquidity needs and reduce credit risk to the extent that the market is pricing many bonds in a similar manner.

TOPICS: Asset-backed securities (ABS), credit risk management, financial crises and financial market history

Key Findings

• ▪ With market-based pricing signals obscured by government intervention, inefficiencies are introduced that can be exploited by portfolio managers to increase spread without taking undue credit or liquidity risks.

• ▪ The reach for risk appears to be alive and well against the backdrop of low all-in yields. The statistical analysis of ABS primary market pricing spreads provides support for the observation that spread tiering remains quite narrow and the market undervalues liquidity as measured by class size.

• ▪ The key recommendation is for investors to buy ABS from larger issuers, deals, and tranches to maximize potential liquidity needs and reduce credit risk to the extent that the market is pricing many bonds in a similar manner.