What is Asset-Backed Finance?
Asset-backed finance (ABF) has emerged as a rapidly growing component of the financial landscape and is estimated to be worth more than US$20 trillion*. It can be very closely tied to the financial plumbing of our economy, yet many investors remain unfamiliar with this asset class. As traditional banks continue to reduce their lending activities in certain sectors, ABF presents both opportunities and challenges for investors seeking diversification and potentially attractive returns.
Asset-backed finance refers to lending that is secured to a pool of underlying assets. This means that loans are supported primarily by the contractual cash flows from the diverse pool of assets (owned within a special purpose vehicle) and secondarily by the liquidation value of those assets which tend to be held conservatively.
ABF is essential to the financing of many day-to-day activities including:
- Residential mortgages: Loans secured to owner-occupied and investment residential properties.
- Consumer finance: Auto loans, credit card loans, student loans.
- Commercial real estate: Loans backed by office buildings, hotels and shopping centres.
- Hard assets: Loans secured by airplanes, data centres, rental cars.
- Financial assets: Loans secured by music royalties, sports media rights, trade finance and corporate loans.
Benefits of ABF
ABF has a number of benefits unique to this asset class (when compared to traditional investments). They include:
- Strong downside protection: Where ABF tends to exhibit lower loss rates than traditional corporate lending. This can be attributed to:
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- Highly diversified underlying assets: Typically, there are hundreds of individual assets within the pool, alleviating the impact of a small number of defaults. As such, systematic risk (also known as undiversifiable risk) such as economic downturn, is typically the main risk of this asset class.
- Strong documentation and covenants: ABF tends to be highly structured allowing for lenders to have stronger monitoring and step in rights, improving their ability to act prior to defaults occurring. This is generally above the covenants afforded to public market lending.
- Bankruptcy remoteness: Assets in ABF tend to be placed in special purpose vehicles which provide legal separation from the originator of the loans. This means that the assets are relatively unaffected even when the originator defaults and does not rely on the originator’s creditworthiness.
- First loss / Structured risk profiles: ABF tends to be highly structured products that contain different tranches which cater for different risk return profiles. As such, investments in ABF may benefit from a first loss piece or lower tranches which are first to absorb capital losses.
- Attractive return profiles: Where ABF tends to provide a higher return when compared to public market equivalent of the same credit quality. This is due to additional premiums in ABF such as the illiquidity premium and complexity premium, particularly in niche sectors where banks and public markets are less active.
- Higher cashflows & margin of safety: ABF tends to have strong yields which provides for high income component to returns as well as natural liquidity due to coupon payments. Moreover, ABF are typically cashflow generative which means that repayments are contractual and constantly being made on the underlying assets level. The underlying assets tend to be well diversified across maturities which substantially reduces refinancing risk compared to traditional corporate lending.
- Low correlation to traditional assets: ABF instruments typically exhibit lower correlation to traditional corporate credit**, enhancing portfolio diversification.
Challenges of ABF
There are challenges associated with ABF which favour fund managers that have the scale, experience, knowledge and certainty to funding. Challenges include:
- Complexity: ABF structures can be complex and require specialized knowledge to evaluate properly. Understanding and managing the underlying assets’ risk, cash flow waterfalls and structuring requires resources and expertise that many individual investors lack.
- Liquidity constraints: Particularly in private ABF structures, liquidity can be limited compared to public markets, potentially locking up capital for extended periods.
- Regulatory and market risks: Changes in regulations affecting either the underlying assets or the ABF structures themselves can impact performance. Additionally, severe market dislocations can affect even well-structured ABF investments.
- Limited accessibility: Many ABF investments are only available at scale to institutional investors or large family offices, making them difficult for average investors to access directly.
How to access Asset-Backed Finance
There are several ways to gain exposure to asset-backed finance which include public securitisations and Business Development Companies. However, the most common and accessible way for an investor to invest in ABF is via specialised private credit funds and publicly traded asset backed listed funds (generally focused on mortgages).
* As estimated by Apollo Global Management in their whitepaper, Asset-Backed Finance: The Next Evolution of Private Credit
** Average correlation of 0.55 to corporate high yield according to Pimco. https://www.pimco.com/us/en/insights/asset-based-finance-quantifying-diversification-benefits-and-return-potential