Institutional investors on the European market are finding it increasingly difficult to unearth investments with positive yield.
European sovereign bonds are in resolutely negative yield territory, while investment grade corporate bonds are also struggling. If we look to the more risky asset classes – such as high yield credit and European equities – valuations do not look very attractive either after a sharp rebound over the first part of the year and against a particularly tough market backdrop characterized by geopolitical risk and trade tension.
So the same question remains across the board: how can we enhance yield without increasing exposure to interest rate risk and exchange rate risk or suffering lower credit ratings?
In today’s environment, it may be worth looking to the European securitization market, which involves asset-backed-securities, or ABS. European politicians are keen to revive sustainable growth in Europe through increasing lending to households and businesses, so have publicly acknowledged the crucial role the asset class plays in financing the real economy. This move has gone a long way to providing new impetus for the European ABS market over recent years with the implementation of the new Simple, Transparent and Standardized (STS) regulatory framework on January 1, 2019, providing a certification for high-quality securitization products. In the fall of 2014, the European Central Bank also decided to include senior asset-backed securities in its asset purchase program, on a par with sovereign bonds, covered bonds and corporate bonds. This move put a squeeze on spreads for this type of bond and was widely seen as a vote of confidence in the ABS asset class as a whole, which has so far proven to be highly resilient, even during the 2007-2008 financial crisis. However, senior ABS bonds are now facing negative yield on a large majority of sub-segments of the European securitization market.
Against this backdrop, a feasible alternative can be found in the shape of mezzanine ABS bonds. This market segment remains small in size compared to the broader securitization market for various reasons. These investments are not currently eligible for the ECB’s asset purchase programs or the liquidity coverage ratio (LCR), so they have not seen the hefty price distortion experienced by senior ABS bonds resulting from the ECB’s programs over recent years. If we take a closer look, despite the fact that mezzanine ABS bonds have gained considerably, driven up by a frantic quest for yield from investors already familiar with the ABS asset class via senior ABS, this market still offers real investment opportunities for sophisticated investors. Yield is deemed to be relatively attractive compared to traditional bonds, while carrying relatively limited risks in our view.
In light of the macroeconomic context and the accommodative stance from all central banks in Europe and elsewhere, this quest for yield looks set to continue.