Mike Nowakowski, md and head of structured products at Conning, outlines the opportunities for yield and portfolio diversification offered by esoteric ABS

Institutional investors navigating market volatility increasingly seek asset classes offering unique yield opportunities and portfolio diversification. One such asset class garnering attention and capital is esoteric ABS.

Esoteric ABS are very similar to traditional auto and credit card ABS, but the collateral may be less familiar. Most esoteric ABS deals can be divided into three large categories based on their collateral: consumer, commercial and/or digital infrastructure.

Benefits to institutional investors
Since the pandemic, rotation into structured products has grown as investors diversify into asset classes that offer structural protections with shorter duration. Esoteric ABS offers investors a similar (or higher) spread level to longer duration investment-grade corporate bonds, but at a fraction of the duration exposure.

Not only are esoteric ABS alternative choices from an investment product perspective, but they also offer a diverse set of collateral options, including prime consumer, subprime consumer, the shipping industry, construction equipment, digital infrastructure and others. Additionally, esoteric ABS currently offer yields at a premium to traditional ABS, as well as other assets of similar quality and duration.

Both from a spread-tightening perspective, as well as a fixed-rate, duration-additive perspective, esoteric ABS will serve a useful purpose for investors’ portfolio allocations going forward. For investors that are also invested in other structured credit asset classes like CLOs, adding fixed-rate duration on the front end of the curve in an environment where the Fed is poised to cut rates should be a good complement.

Changes since the GFC
Many may remember esoteric ABS from the 2008-2009 financial crisis. However, much has changed since then.

When most of us think of the deals of that era that experienced heavy losses, we think of over-levered consumers with subprime mortgages at high debt-to-income ratios. But esoteric ABS are very different from legacy RMBS products.

For starters, the collateral backing esoteric ABS deals is not mortgage-related. In addition, the underwriting process has become more efficient, and lenders have done a much better job at managing the risk within their respective credit boxes. Most importantly, the structural protections in esoteric ABS deals issued after the financial crisis have higher levels of credit enhancement.

Levels of credit enhancement at the single-A level across various subsectors more than account for the level of 60-plus day delinquencies currently seen in the market. Even if all those delinquencies came through as defaults, there would be sufficient credit enhancement to enable these tranches to continue to pay principal and interest to investors. Additionally, rating upgrades are common in esoteric ABS, as many deals amortise over time and build credit enhancement in the process.

Navigating the current market
Present day, the current interest rate environment has affected the asset class, but opportunities persist. Performance for esoteric ABS was challenged in 2022 as the Fed embarked on an aggressive rate hiking campaign and spreads widened into the broader risk-off environment.

Consequently, the inverted nature of the Treasury curve at present makes the front-end of the duration spectrum very attractive. Add wider spreads on top of that, and esoteric ABS offers a very attractive entry point and an appealing yield per unit of duration.

There are a few dynamics driving the esoteric ABS market, but two are currently commanding a lot of attention from investors and managers alike.

One is the Red Sea conflict, which has global ramifications for the shipping industry. Container ships are rerouting around the Horn of Africa, adding 20%-30% to travel time, which is causing shipping rates to reprice significantly higher.

This is a challenge for the shipping industry, but it’s great for container lessors (who issue ABS deals) because operators will need more containers and more container ships to make up for the delay in deliveries. As a result, container utilisation and demand will rise, improving the fundamentals of container deals.

The second dynamic concerns the aircraft industry, which has also been in the headlines. However, there are reasons to be optimistic about lessors in the space.

There is a global shortage of aircraft, particularly engines, now that air and passenger traffic is back to pre-pandemic levels. Narrowbody aircraft and engine lease transactions offer solid fundamentals and typically come at very attractive spread levels.

What to expect in 2024
For the remainder of 2024, there are two items on the radar that are significantly affecting the esoteric ABS market. They include the evolution of the US consumer and the rise of digital infrastructure and artificial intelligence (AI).

The health of the consumer has been a big topic of conversation during the past 18 months, but it is more nuanced than the US consumer en masse; data show that it has been a story of the prime consumer versus the subprime consumer.

The prime, homeowning consumer has enjoyed rising home prices and equity markets as well as an increase in wages. As a result, delinquencies for prime-related ABS collateral have been well contained.

On the other hand, delinquencies are rising above 2008-2009 levels for subprime auto and unsecured consumer loans as inflation has affected the lower-FICO-score, paycheck-to-paycheck borrowers to a greater extent. However, the market is approaching an inflection point in delinquencies and can expect better consumer metrics into 2024.

The recent rise in AI has led corporations and individuals to demand greater computing power. This has led to an increase in corporate capital expenditures in digital infrastructure.

As a result, there has been significant growth in digital infrastructure-related ABS in the form of data centre and fiber network deals. Data centres offer cashflows backed by the leases on the centre’s tenants, which can vary by scale in the form of colocation, wholesale and hyperscale. As the need for computing power (and more importantly, space) expands, growth and subsequent issuer tiering in this sector will continue to develop.

With borrowing rates poised to come down this year, we anticipate a good year of issuance in the ABS space and are optimistic about the fundamentals. Through ongoing evolution and adaptation to market conditions, esoteric ABS are poised to play a significant role in institutional investors' portfolios, offering both stability and yield in an ever-changing financial landscape.