Money is once again pouring into high-yielding, low quality asset-backed securities and collateralized loan obligations, as investors are once again taking significant risks in the euphoria-driven chase for yield. As Bloomberg reports, a decade after the great financial crisis, investors are again making the same mistakes that led us to financial turmoil in 2008. Thanks to suppressed volatility, and cheap debt investors are getting greedy and are seeking out higher yields.
According to the report, high yield ABS are on track this year to account for its biggest slice of the overall sector since before the financial crisis, rising to 1.5%, up from 0.3% in 2012. At the same time, the riskiest CLO notes are now a larger percentage of the market than they’ve been in two years.
The growing appetite for the lowest-rated bonds in the ABS and CLOs markets highlight the rabid demand for higher-yielding securities and those with floating rates that offer protection from inflation and tighter monetary policy. But this also leaves these markets more exposed at a time when many analysts see an economic slowdown on the horizon.
“From a debtholder’s perspective, I am very wary of these types of lower-rated tranches, as they have been shown to have much more spread volatility and much more rating risk,” said Jason Merrill, a structured finance analyst at Penn Mutual Asset Management, about the collateralized loan obligation and asset-backed securities markets.
While some of the asset backed securities are for personal loans, the bulk of investor interest is for high-yield securities in the automobile sector, whose subprime segment has deteriorated significantly in the past two years. Subprime auto ABS has less of a safety net than it did prior to 2008, as insurance has fallen off since the last financial crisis. However, this hasn’t stopped speculative investors with euphoric outlooks from blindly taking more risk:
The popularity of subprime auto ABS -- especially the rise of B rated tranches -- is a concern because there are fewer protections baked into the structures of the deals than before the financial crisis, S&P Global Ratings analysts said in a note Monday.
Bonds rated BB typically were insured in the 1990s, featuring important triggers to protect investors. But insurance hasn’t been used as a form of credit enhancement in this market since 2008, so the latest batch of subprime deals -- many of which now go all the way down to B ratings -- doesn’t have the same safety net, according to S&P.
The article also observes that the B-rated tier in the CLO market has grown to a total of 30% of all new issues. This is up from 17% last year and just 3% in 2016:
“When I consider the CLO downgrades that come across the wire, the vast majority of them are single-B to CCC downgrades,” said Merrill, whose firm has more than $24 billion of assets under management.
For example, Moody’s Investors Service downgraded the B2 rated tranche of a 2014 CLO managed by Invesco last week, while upgrading or affirming the ratings in the higher tiers.
The push into the lowest rungs comes amid record demand. New CLO deals may be on pace to reach an all-time high of $150 billion this year, according to Wells Fargo.
We have repeatedly reported on the implosion of the subprime auto market for the better part of the last year. In May, we showedthe rapid deterioration in the subprime auto market, which now looks worse than prior to the last recession. Specifically, delinquent subprime auto-loans are now higher than they were in the last recession, as shown in the chart below:
What’s interesting – and worrisome – is that consumers are defaulting on subprime auto loans when the economy is reportedly doing ‘very well’.
As a Zerohedge contributor wrote in early May – there are cracks under the economy’s foundation. And it’s like a bucket of cold water in the face of the mainstream financial media that’s pushing the ‘growth’ story. We must ask ourselves – “if things are going so well, why are subprime loan delinquencies at a 22-year high?” This was the same situation that led up to the 2008 housing crisis.
First, there was massive growth in mortgage-backed securities and mortgage debt. Then, the Federal Reserve – led by Alan Greenspan – began aggressively raising rates after years of low rates. Soon after, subprime loans started blowing up – which trickled into the prime loans. And eventually, everything was in chaos.
Thanks to the Fed, a near decade of ZIRP and three rounds of Quantitative Easing (which totaled over $3.8 trillion in printed money) – consumers became hooked on cheap auto loans.
One thing is for sure, pouring more money into riskier paper in a chase for yield is a mode of operation we have seen many times before and it always ends badly. Meanwhile, investors refuse to learn from past mistakes and, with the help of the Fed, we are doomed to repeat history again.
Maybe it is different this time.