By Antonio Serpico

Various asset classes in the U.K. and Europe are reacting differently to higher interest rates.

European asset-backed securities and residential mortgage-backed securities (RMBS) were among the world’s best-performing fixed income asset classes during the recent monetary tightening cycle, given their insulation from duration risk.¹ Looking at fundamentals, however, the performance of some collateral has been deteriorating since 2022, as higher interest rates have affected loan affordability. This is particularly true for collateral portfolios backed by floating-rate loans and loans converting to floating rates after an initial period of fixed-rate payments.

In the RMBS sector, the picture is clear: Lower-quality borrower pools indexed to floating rates are experiencing the biggest increases in arrears. This is evident in U.K. nonconforming/”buy-to-let” and Irish reperforming loan transactions.² On the other hand, fixed-rate mortgage loan markets in France, and to some extent, Spain, the Netherlands and Italy, are experiencing steady performance and low levels of delinquency. In these countries, affordability has not diminished given that loan installments are mainly at fixed rates or are generally still in their reset period.

For these reasons, we currently tend to favor mezzanine tranches of Spanish, Italian and Dutch RMBS, whereas we would focus on the senior part of the capital structure in those asset classes with deteriorating collateral performance, such as U.K. non-conforming and buy-to-let. Despite a general deterioration of collateral performance in these portfolios, appealing value is available in first-pay tranches. These bonds trade at wider spreads than European peers due to weaker collateral but benefit from credit enhancement and robust structures. Additionally, their extension risk is decreasing as the recent spread rally has improved the economics of calls. Finally, the health of the U.K. and European job markets remains strong, and governments are granting higher levels of support to indebted homeowners.

A similar picture is visible in consumer/auto loans: The fixed-rate nature of the collateral has helped preserve affordability, resulting in only a slight increase in default rates, which is offset by structural protections and fast deal deleverage, as auto/consumer loan portfolios have short-weighted average lives. For these reasons, we like mezzanine tranches of European auto loans/leases and consumer loans. These bonds offer compelling yields compared to similarly rated credits while being relatively short in nature, thanks to the short maturities of the collateral. This last point also ensures quick deleverage of structures with a fast increase in credit enhancement, which we see as paramount for mezzanine tranches, which are the most exposed to collateral losses.

Source: (1) Bloomberg. Bloomberg Pan European Floating ABS Bond Index AAA total return from January 1, 2022, to October 18, 2023, (2) Intex, KBRA. U.K. buy-to-let 30+ days arrears have risen to a weighted average of 6.6% in May 2024, exceeding the 6.1% reached during the global financial crisis.

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