The Return of Subprime Debt?
Swooping into sectors left cratered by the global financial crisis, hedge funds have found that the surest bets in recent years are in mortgages and other asset-backed securities.
Greg Richter, who co-manages the $950 million Candlewood Structured Credit Fund, says the reason lies in the mix of return and risk in securitized debt, Bloomberg Markets magazine will report in its July/August issue.
“Some of it’s the opportunity, the beta,” Richter says.
The asset-backed-securities market as a whole offers yields of about 8 percent, he says. Much of the rest of the fixed-income world is providing less return.
Results from the Bloomberg Active Indices for Funds, which aggregate return and risk data by strategy, back up his point.
The top-performing hedge-fund strategy from January 2011 through May 2014 was investing in mortgage-backed securities, with a total asset-weighted return of 54 percent. Mortgage-backed was followed by the asset-backed category, with a gain of 46 percent. That’s not all: The two strategies registered the smallest monthly losses, the lowest proportions of down periods and the highest Sharpe ratios, which measure risk-adjusted performance.
The Candlewood Structured Credit Fund, which Richter oversees with co-manager Brian Herr, returned a cumulative 80 percent over the period. Its only down month since its inception in January 2011 was June 2013, when the fund recorded a 1.6 percent dip, according to company data.
Credit Suisse Roots
New York–based Candlewood Investment Group LP traces its roots to a credit hedge fund started within Credit Suisse Group AG. The fund was spun out in 2010 and now oversees $2.8 billion in assets. Of that total, about $1.5 billion is invested in two structured-credit funds managed by Richter and Herr. The rest is focused on event-driven and distressed corporate credit strategies, including the Candlewood Special Situations Fund.
Candlewood’s structured-credit investments are spread across a dozen niches of the market, including bonds backed by aircraft operating leases, student debt, subprime mortgages and collateralized debt obligations, Richter says.
“We’re constantly searching for what we believe to be undervalued CUSIPs,” he says, referring to the identification numbers assigned to bonds. The managers look to resell what they find to buyers who value the bonds differently, on average turning over more than 20 percent of the fund’s portfolio each month.
“We’ve got a lot of trading DNA,” Richter says.
Returns Persist
Relatively high returns persist in the securitized market because, for one thing, many bonds have low credit ratings.
“What we have is a lot of triple-C- and D-rated securities because the rating agencies are still trying to rate the return of principal at par,” Richter says. “It keeps a lot of the deep-pocketed investment-grade buyers out of our market and allows us to trade at still-attractive yields.”
Candlewood has no illusion that it will receive 100 cents on the dollar for the bonds it buys.
“We’re buying these securities at 50; we want to get 70 back,” Richter says.
The labyrinth of the securitized-debt market is a barrier to entry for competitors.
“There’s so much information, so much innovation, so much structural complexity, so many different credit enhancements that have been used in these different sectors,” he says.
Another obstacle is sourcing bonds, according to Herr.
“If you haven’t historically been involved in some of these markets, it gets tougher to leap in,” he says.
The upshot, Richter says, is that in contrast to the corporate bond market, “there are mispriced cash flows left and right.”
Largest Holdings
The fund’s largest holdings as of April were in nonagency, subprime mortgage-backed securities, which accounted for 29 percent of its portfolio. The next-biggest sectors were aircraft-related debt, at 14 percent, and commercial mortgage-backed securities, also at 14 percent.
Each subsector has its peculiarities, Herr says. One holding is aircraft bonds issued before the Sept. 11, 2001, attacks on the World Trade Center and Pentagon. Airlines often don’t own the planes they use, choosing instead to lease them from special-purpose vehicles that buy them with funds raised in bond sales. In the wake of Sept. 11, such bonds plunged to as low as 75 cents on the dollar as lease rates were cut by a third.
“A lot of planes were parked in the desert,” Richter says. “The deals in essence blew up in 2002 and 2003.”
Aircraft ValuationWelcome to the murky world of structured credit. This is a good article because it highlights the difficulties pension funds have directly investing in subprime debt (they basically can't because of their investment policies) and the advantages these specialized structured credit funds have using their expertise to source and invest in subprime debt.
Another complication for the securities is how the valuation of an aircraft changes as it ages.
“Oil prices are one of the things that can really move the value of these planes because the older ones tend not to be as fuel-efficient as the newer ones,” Richter says.
Airplanes can also throw off cash when they go out of service and get sold off for parts, he says. Aircraft bonds and other asset-backed securities differ from corporate junk bonds in that way, Richter says.
“They are amortizing, self-liquidating securities,” he says. By contrast, getting paid back on a junk bond often depends on refinancing. A high-yield issuer needs to remain leveraged to function, Richter says.
“Our deals naturally delever; the payments from the underlying loans or leases are captured in the trust to pay down debt,” he says. “They don’t need a capital markets event to pay you back.”
The article also highlights the return of subprime debt and how the hunt for yield is driving spreads lower. In fact, Subprime Trading Like It’s ’07 in Car-Loan Bonds:
In response to rising default rates on subprime U.S. auto loans, bond investors are deciding the best thing to do is pile into securities backed by the debt.
In the market where auto loans to people with spotty credit are bundled into bonds, the difference in yield between the lowest-rated securities and the safest has narrowed to the least since August 2007, according to Wells Fargo & Co. data. Demand for the bonds is translating into cheap funding for lenders, allowing them to make even more loans though payments more than 60 days late are on the increase.
Investors are turning to riskier debt to boost returns as stimulus measures from central banks around the world suppress interest rates. The European Central Bank last week became the first to take one of its main rates below zero, underscoring the lengths to which policy makers are willing to go to jumpstart growth more than five years after the worst financial crisis since the Great Depression.
“People have to reach further and further,” said David Schawel, a money manager at Square 1 Bank in Durham, North Carolina. “The objective now is to reach a certain yield target instead of feeling good about the underlying credit.”
Yields on subprime auto-loan bonds rated BBB have fallen to within 65 basis points of those ranked AAA, down from 124 basis points a year ago, Wells Fargo data show. A basis point is 0.01 percentage point.
Market Revival
Issuance of securities backed by the debt has reached $10 billion this year, up 5 percent from the pace in 2013 through May 30, according to Wells Fargo. Total sales of $17.6 billion last year were more than double the $8 billion sold in 2010, when securitized-debt markets started to revive after all but shutting down amid the 2008 financial crisis.
Aided by low interest rates, the U.S. auto industry has been one of the bright spots of the economic recovery. Vehicle sales rose 11 percent to 1.61 million in May, bringing the annualized pace to 16.8 million, the most since February 2007, according to researcher Autodata Corp.
The economy contracted at a 1 percent annualized rate from January through March, the first decline in three years. An unexpected drop in spending on health-care services means gross domestic product probably shrank even more in the first quarter, according analysts at JPMorgan Chase & Co. and Pierpont Securities LLC.
Investors are increasingly willing to look at smaller, less-established firms in the subprime auto segment to boost returns, Wells Fargo analyst John McElravey said in a telephone interview.
27% Interest
Tidewater Motor Credit, a Virginia Beach, Virginia-based lender, sold $145 million of bonds last week that are backed by 7,438 loans carrying interest rates ranging from 9.45 percent to 26.55 percent, deal documents show. The transaction marks the first asset-backed bond offering for the company since 2012, according to data compiled by Bloomberg.
GM Financial Inc., the subprime lender acquired by General Motors Co. (GM) in 2010, boosted its asset-backed bond sale by $200 million earlier this month to $1.4 billion in its largest such offering since 2007, according to data compiled by Bloomberg.
Bond investors were paid a yield of 120 basis points more than the benchmark swap rate to buy the bonds rated BBB and maturing in four years in the June 3 sale. That compares with a spread of 175 basis points on similar debt sold in November.
Blackstone Acquisition
The subprime auto segment has ballooned since contracting following the financial crisis. Private-equity firms, attracted by the high margins, have flocked to the business during the past three years. New York-based Blackstone Group LP (BX) acquired Irving, Texas-based subprime lender Exeter Finance Corp. in 2011, the same year that Perella Weinberg partnered with CarFinance Capital LLC.
The influx of new players to the business has fueled concern that companies are lowering underwriting standards to win business.
“Subprime auto lending from banks, captive finance companies and credit unions continues to increase and is pressuring more traditional subprime lenders to lend to ever-weaker borrowers to maintain lending volumes,” Moody’s Investors Service analysts led by Peter McNally wrote in a January report.
The percentage of subprime auto loans that are more than 60 days late rose to 2.75 percent in March from 2.24 percent a year prior, Standard & Poor’s said in a report last month, citing the latest available statistics. The delinquency rate on loans to the most creditworthy borrowers was about flat at 0.28 percent.
Lender Pushback
Defaults on the debt are climbing as the segment reaches an “inflection point” with borrowers falling behind and loan terms easing, S&P analyst Amy Martin said in an interview in March.
Losses on the debt, though still within expectations, jumped to 4.45 percent in March from 3.88 percent a year earlier, according to S&P.
Some lenders are pushing back against deteriorating underwriting standards, becoming less willing to extend loans to increasingly risky borrowers, according to Moody’s. Borrower credit scores for used car loans improved in the fourth quarter of 2013 for the first time since 2010, the rating company said in an April report.
Lengthening loan terms and rising debt burdens relative to the value of a vehicle show that lenders are still taking on more risk, the Moody’s analysts led by McNally wrote in the report.
Yield GapThe explosive growth in subprime auto lending is a cause for concern but as employment growth picks up steam in the U.S., and interest rates remain at historic lows, you will see new-loan volumes remain very high. That can change if interest rates back up considerably but for now, this isn't a major concern (nor should it be as long as the euro deflation crisis persists).
Top-ranked securities linked to the debt are yielding 45 basis points more than the benchmark rate, compared with 36 a year ago, according to Wells Fargo. Bonds rated BBB, two steps up from non-investment grade status, are 110 basis points more than swaps, down from 160, the data show.
New-loan volumes are likely to remain high in the subprime auto segment at least through 2015 even as some lenders pull back, according to Moody’s.
“Since lenders will still continue to vie for borrowers, we don’t expect a major slowdown in subprime lending,” the Moody’s analysts said. “Competition will continue to pressure the credit quality of new originations as lenders fight for business.”
Nonetheless, the Office of the Comptroller of the Currency highlighted two areas where banks are taking on more risk to pursue profit: Leveraged loans and indirect auto loans (where banks buy loans originated by car dealers). The report calls out "erosion" and "loosening" in underwriting standards, including an easing of lending standards in commercial loans.
Below, Chris Whalen, senior managing director in the financial institutions ratings group at Kroll Bond Rating Agency, talks to Yahoo's Lauren Lister about these concerns.
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