Stomaching Subprime: Seeking Value in Auto ABS

Subprime. It’s the eight-letter word that turned into something of a four-letter word during the 2008 global financial crisis. Even now, ten years later, that stink has not washed off. Investors have been eyeing subprime auto asset-backed securities (ABS) for signs of trouble, wondering if growing auto debt levels, rising interest rates, deteriorating performance and changing issuer composition could mean the next subprime storm is brewing.

So is it? I don’t think so. Yes, delinquencies and losses in subprime auto have risen, and that’s nothing to dismiss. But I think it’s more important to look at the fundamentals of the borrowers, issuers, and deal structures in the subprime auto ABS market. In my opinion, investors who focus on fundamentals and are undeterred by the sector’s infamous moniker may find compelling value propositions.

Fundamentals in focus

Here’s my assessment of the subprime auto ABS sector:

1. Borrowers: Subprime performance is highly correlated with employment. Auto debt is most often related to the borrower’s need to get to work, and those with a job generally pay their auto loans. Unemployment is extremely low today, and now that the economic recovery has matured, lower-income earners are finally starting to feel wage gains (which tend to accrue to prime borrowers earlier in recoveries). Are rising rates an added stressor? The reality is subprime borrowers are always under financial pressure. This group actually feels less pressure from rising rates than their prime counterparts because they are already paying high interest rates—sometimes the maximum rate allowed by law.

2. Issuers: A lot of subprime auto ABS issuers also service the underlying loans. This means they have skin in the game—the issuer will often hold interest in the ABS deal, but they don’t get their money until after more senior investors have been paid. This is an important difference versus the pre-crisis mortgage market, where loans were made to be packaged and sold to other investors, so originators/issuers didn’t retain any risk. I see this as a big positive, but I am still selective about aligning with experienced issuers and servicers whom I consider best equipped to deal with complex borrower behavior. For example, has the management team been through a full economic cycle? Do they have the right technology in place? Can the servicers chat online with a customer? Or text? Come on, who answers the phone anymore?

3. Deal structure: Subprime auto ABS deals are comprised of loans with high rates of interest, and this typically creates a big spread between the interest income the deal takes in and what it pays out to bondholders. The difference is excess spread, a form of credit enhancement that is the first line of defense against losses. In a typical structure, the classes are paid sequentially, with deal cash flows applied to the most senior classes first and losses absorbed from bottom to top. This allows credit enhancements to build over the life of the deal. So a deal that may have +20% cumulative losses and high delinquencies does sound hairy, but remember borrowers don’t become subprime borrowers because they pay their bills on time. With the right structure and credit enhancements, high levels of delinquencies and losses can pass through a deal without most investors ever taking a loss.

Risks to monitor

I’m comfortable with a lot of what I see in subprime auto ABS right now, but of course there are risks. I am always looking for factors pressuring consumers that may not be in the headline numbers. Right now, that includes healthcare costs, increasing rents and home prices, and high levels of student loan debt. I also watch how the consumer prioritizes debt—which bills are paid first, and which do they let slide? Auto debt has held the top repayment spot since the financial crisis, but now cellphones are a major challenger.

There’s one additional risk that is much harder to quantify: the unintended change in consumer attitudes toward debt as a result of the Consumer Financial Protection Bureau and its protective measures. Some issuers across the credit spectrum have commented that people seem to feel less obligated toward debt in a post-crisis world, believing “it’s the lender’s problem, not the borrower’s.” This consumer behavior will be something to monitor.

What’s (really) in a name?

One of the sector’s biggest issues is really its tainted subprime name. For investors who can stomach that, I believe the subprime auto ABS sector can present potential investment opportunities with attractive yield and short duration for a range of risk appetites.

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