This year has seen the launch of a number of investment trusts targeting more unusual forms of debt. The latest entrant to the pack is Threadneedle Asset Backed Income (TABI), with an initial public offering expected later this month, which will target asset-backed securities (ABS).
These kinds of bonds are best known from the financial crisis when repackaged US sub prime loans didn't deliver as intended, leading to declines and defaults of the bonds backed by them, and causing investors to largely avoid all ABS. So why target an asset with such a tainted reputation?
"What caused the problems in the US market were losses on mortgages but we are not looking at US mortgages," says Henry CookE manager of TABI.
He points out that out of a global universe of about $8 trillion asset-backed securities, Threadneedle Asset Backed Income will focus on only around half of that. "The performance of ABS has been extremely strong with the exception of the US mortgage market where losses have been considerably higher," he says. "A reason for this is because US mortgages are very different."
Residential mortgage backed securities (RMBS) in Europe, the UK and Australia typically have many layers of protection for bond investors. For example, on default lenders have recourse to the borrowers if a loss is incurred on the foreclosure of the secured property. However, this is not the case in the US.
"You can find really high quality securities and still get pretty compelling yields," he says. "The fundamentals for ABS are very good value relative to other areas of fixed income."
For example, while triple B-rated mezzanine Australian RMBS yield 7.2 per cent or triple B-rated UK commercial mortgage-backed securities yield 4.8 per cent, a European triple - rated corporate bond offers only 2.8 per cent. And to get yields in excess of 4 per cent among government bonds you need to turn to higher risk areas such as southern European countries, which have experienced problems like Spain and Italy, or emerging markets such as Mexico.
If you want yields of about 4 per cent-plus in other types of fixed income you also have to take a lot of duration risk. Most ABS are floating rate over three-month Libor reducing sensitivity to longer-term inflation and interest rate rises.
"We have also had a chance to see how ABS performed over the last five years," adds Mr Cooke.
Strong loss adjusted returns are available for asset-backed securities that are less easy to trade, while the strong credit protections of these mean they are expected to perform even in falling gross domestic product environments.
Opportunities
European asset backed securities offer opportunities because there are fewer potential investors chasing them than in the US, and fewer again in Australia, meaning the latter can be picked up at a much lower cost. Beyond mortgages there are also some US opportunities, for example, credit card and auto loan backed ABS.
Small to medium-size enterprise loan backed ABS is also an area of interest. "You get lots of principal back from day one with these, and the deal deleverages quickly," he explains.
Junior securities (tranches of bond issues lower down the repayment priority scale) give the kind of returns he is looking for, although investment grade securities (bonds rated triple B or above) which are considered less likely to default, will still account for at least 50 per cent of assets. The trust will also be able to invest in unrated assets, though these will be capped at 10 per cent of assets. "These are less liquid but give a better return," says Mr Cooke.
Other than the unrated assets the trust will not invest in anything below a single B rating.
Threadneedle Asset Backed Income is targeting a 5 per cent dividend in its first year, rising to 6 per cent a year thereafter, and a net total return of 7 per cent to 9 per cent.
"Our total return will be driven by the fact that some of these securities are discounted," adds Mr Cooke.
The asset class is overlooked by many investors as it is one of the last areas to recover from the crisis, and so under researched providing opportunities for active investors.
Picking the right bonds
When choosing which deals to invest in Mr Cooke looks at factors such as the term of the underlying loans, aiming for quick deleveraging and amortisation, and assesses whether they can make a projection of the return. "If we can't we won't invest," he says.
He also looks at economies around the world and considers what kinds of assets are likely perform well in them. "We look at the loan data and how they will perform in stress, and consider as to whether we are comfortable with the protection built in," he explains.
Risks are largely economic so he needs to assess what will drive delinquency and default, for example employment.
He then looks at the universe of securities available within this and how they stack up.
Important considerations also include what losses are likely and how much protection they have built into the bond issues such as excess loan interest. This is loan interest of a value above senior expenses and bond coupons.
He also considers if the loans will pay everything back. "We will only buy where we think we will get the full return of principal," he says.
Investment will largely be focused on the US, UK, Australia and Europe. "It is important to understand the underlying legal system, and this varies from country to country," he says. "There is a lot of ABS issuance from Korea, for example, but we are not clear on the legal system.
"We are trying to find the best value around the globe and while we don't want to restrict ourselves, we want to ensure capital preservation - the primary driver of investment decisions."
