Second quarter review – banks step back, direct lenders step in
Broadly syndicated ABS issuance remained robust against a backdrop of fears around credit contraction. Second quarter volumes for ABS issuance exceeded $68 billion, up from $60 billion in the first quarter. Spreads in public ABS markets remained range bound to slightly tighter, contrasting against wider spreads across the capital structure in broadly syndicated CLOs. Fundamentals are slowly creeping into the narrative for both traditional ABS and CLOs. Delinquencies for consumer assets are drifting higher alongside declining free cash flow for bank loan issuers. Currently these are manageable, but markets are still searching for clarity on the duration of Fed rate hikes and evidence of a soft landing.
In the second quarter two trends converged, resulting in a tangible opportunity in private ABS:
1. Turmoil in the regional banking system has prompted lenders to tighten standards around corporate lending.
2. Elevated levels of private equity (PE) investments by firms large and small continue to fuel demand for private credit and more specifically, direct lending.
To the first point, as banks step back from corporate lending, non-bank lenders (private credit firms via funds, rated notes or Business Development Companies) are stepping in to fill the void. Aegon AM has observed an increase of inbound activity from banks looking to reduce exposure as well as from non-bank lenders structuring middle market CLOs as an alternative financing source. Funding costs have increased as result of this dislocation, presenting an attractive opportunity for allocation.
To the second point, today, middle-market, corporate loan originators enjoy the benefit of underwriting to companies under higher base rates and companies’ specific business challenges. To further strengthen the deals for investors, lenders also work directly with presiding PE sponsors when business plans face challenges, relying on the sponsors to inject capital if necessary.
Where does private ABS come in? These trends have synthesized into structured finance opportunities at the senior-secured part of the capital stack. Why? The wider spread levels in the direct lending space present an opportunity to structure additional credit enhancements (subordination, overcollateralization, excess spread, etc.) and help provide originators both flexibility and surety of execution in deploying capital. While private, direct lending is subject to the same macro risks seen in the public high yield and leverage finance markets (default, industry and interest rate risks), several mitigating factors help make it an attractive investment for insurance companies when in a structured ABS format, including:
1. Economic alignment with PE sponsors through their large equity commitment.
2. Stronger, privately negotiated credit agreements versus broadly syndicated markets.
3. Low leverage levels provide increased financial flexibility to help withstand shocks.
4. Bilateral agreements, which allow for closer lending and restructuring relationships.
Third quarter expectations – private structuring continues to fill the void
Markets are functioning well despite the economic uncertainties. As such, we maintain conviction that premiums available in private and esoteric ABS continue to present a very attractive opportunity over traditional corporate bonds as credit spreads continue to discount these uncertainties. This quarter’s deal spotlight (sidebar) highlights a synergy between direct lending and structured finance. Generally, we expect the importance of private structured finance solutions in filling the void of traditional bank lending to continue through the third quarter and the remainder of 2023.
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Authors
Jim Baskin, CFA, CPA,
is head of US private structured finance responsible for expanding the firm’s global private structured finance capabilities. He is also a portfolio manager for US Structured Finance and US Securities Opportunities strategies. Prior to his current role, Jim was head of US structured research and has spent the last 26 years investing in private ABS markets and complex esoteric ABS structures. He first joined the private placements group specializing in asset-backed securities (ABS). Since then, he assumed increased responsibility in sourcing, analyzing, executing, and managing structured products in public and private markets. Prior to his current role, he was employed by the Federal Deposit Insurance Corporation where he served as a commission bank examiner in the safety and soundness division. Jim has been in the industry since 1990 and started with the firm in 1996. He received his BS in finance from the University of Tennessee. Jim has earned the right to use the Certified Public Accountant designation and is a CFA® charterholder.
Greg Podhajsky, CFA,
is a senior investment manager responsible for supporting the efforts to expand the global private structured finance capabilities and providing private ABS research, underwriting, and analytical research. Prior to his current role, he provided public ABS research, underwriting and analytical support to the US public structured research team. Before joining the firm, Greg was a senior credit analyst in the commercial loan division at Firstar Bank responsible for determining the creditworthiness of the borrower as well as training and managing the workflow of a six person credit analyst department. He has been in the industry since 1991 and started with the firm in 1995. Greg received his BBA in business and his MBA from the University of Iowa. He is a CFA® charterholder.
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Exp date: 11/30/2023
