Squeezing extra yield from US dollar cash has become a little more rewarding (and dare we even say exciting?) now that, for money market funds in general, the Federal Reserve (Fed) is raising interest rates and, for prime funds in particular, the U.S. Securities and Exchange Commission (SEC) has implemented money market reform.
Due to near-zero interest rates and massive quantitative easing programmes over the last decade, money markets funds had not been as attractive as bank deposits for a number of market participants. Now, however, this situation is changing. Some of the reversal is due to changes in money market fund yields; some of the reversal is due to Basel III regulation, which has caused banks to shed a significant amount of non-operational overnight and short-term deposits (Exhibit 1 and Exhibit 2).
In December 2015, with labour and inflation indicators moving towards targets, the Federal Reserve initiated the process of normalizing monetary policy, raising interest rates for the first time in almost 10 years. Since then it has hiked twice more, most recently in March of this year (Exhibit 3). Prior to the first hike, government money market funds yielded close to 0%. After three interest rate hikes, they now yield approximately 0.70%, which is a lot more competitive.
In October 2016, the SEC introduced US money market industry reforms, requiring institutional prime funds to implement liquidity fees and gates in times of stress and to float their NAV. These changes caused hundreds of billions of dollars to switch from prime funds into government money market funds. As a result of this flow of funds, the approximate yield differential between prime funds and government money market funds went from 10 basis points (bps) in late 2015 to 35 bps today. At about 1.05% yield, prime funds may now represent a very attractive option for cash investors vs. government money market funds and bank deposits.
A rising rate environment benefits low duration strategies, particularly money market funds—as discussed in J.P. Morgan Global Liquidity’s “Rising Rates” white paper. Compared to history, however, the current pace of hikes is relatively slow, which means a small amount of extra duration has enhanced returns without adding a significant amount of risk. In fact, the sweet spot for front-end investors in this hiking cycle has been in ultra-short strategies, which have a yield of between 1.2% and 1.6% while targeting a weighted average duration of about half a year.
With this in mind, US dollar money market funds and ultra-short strategies appear increasingly attractive, the former as a vehicle for liquid cash and the latter as a way to effectively shorten duration risk while maintaining a decent risk-adjusted return. With so much front end cash in motion, what strategies will you choose?
Prime funds are money market funds governed by Rule 2a-7 of the Investment Company Act of 1940 that can invest in both government and credit securities.
Government money market funds are money market funds governed by Rule 2a-7 of the Investment Company Act of 1940 that can only invest in government securities.
‘Rising Rates; managing liquidity through periods of rising interest rates’, J.P. Morgan Asset Management; as of 30 September 2013.
There have been No Shortage of Subprime Auto related articles featured in news outlets recently. Each of which has captured the renewed focus of the investment community on the industry’s trends in lending standards, loan performance and their subsequent effect on subprime auto ABS. The commentary written has primarily highlighted a concern for deteriorating credit metrics citing increasing delinquencies, higher loss severities, and the resulting uptick in annualized loss rates. Weakening metrics do warrant heightened concern and media coverage, but these articles tend to oversimplify many of the reasons why this deterioration in industry level loan performance has occurred, as well as, fail to inform readers to what extent these negative credit trends could potentially have a material impact on subprime auto ABS.
Many of the aforementioned articles have referenced the charts below (Exhibits 1 and 2) as a way of portraying the negative credit trends in this industry. Most startling of which is the progressive increase in the subprime auto delinquency rate over time compared to the muted trajectory of delinquency rates in the prime auto market. Also of note is the trend-line uptick in annualized net loss rates in the subprime market, most noticeable in the year-over-year change since 2013. At a glance, these trends appear concerning but there is an underlying dynamic that is not apparent when these charts are taken at face value, especially as it relates to ABS securitizations issued in the sector.
The post-crisis years have been particularly expansive for the automotive lending industry, as the auto sector’s recovery has occurred at a faster rate than other sectors of the U.S. economy. By way of example, total U.S. consumer debt is still slightly below its 2008 peak, while total U.S. auto loan debt outstanding has exceeded $1.15 trillion compared to the pre-crisis peak of $0.82 trillion As a result of this growth, the auto ABS market has thrived. Roughly $90 billion in auto-related ABS was issued last year and the total amount of auto ABS outstanding is back to a level near its peak of $200 billion. Similarly, subprime auto ABS issuance has recently surpassed its pre-crisis equivalent level (Exhibit 3). This growth comes at a point in time when only 35% of the auto industry’s total loan originations are issued in ABS securitizations, with the remainder continuing to reside on lender balance sheets.
Following the 2008 financial crisis, the composition of the industry shifted substantially and has continued to develop. In 2007, a small contingent of issuers represented the lion’s share of total debt issuance. In contrast, there were close to a dozen programmatic issuers in this space in 2016. This expansion in the number of originators has led to a natural increase in competition, resulting in lenders loosening credit standards, adjusting loan terms, increasing loan-to-values, and reducing pricing, as ways of scaling their business models and building their total loan and servicing portfolios.
The expansion of potential borrowers that lenders are willing to underwrite and lend to has also affected the subprime auto ABS market. In 2016, 29% ($7.6 billion) of subprime auto ABS notes issued were backed by loans with an average credit score of 550 or below, versus 13% ($2.3 billion) in 2007. Lending to this segment naturally generates both higher levels of anticipated delinquency and loss rates because of the lower credit quality of the borrowers. Compounding this effect has been a softening of used car prices lowering the recovery rates of defaulted loans. To offset these higher levels of anticipated loss and reflect the deterioration in collateral performance, securitizations carry additional levels of credit enhancement.
To date, both increased loss rates and regulatory compliance costs have had the greatest impact on the equity owners of the subprime auto issuers, lowering the business’ total profitability and return on equity as a result. But this dynamic has yet to have a material impact on the investment grade bonds of subprime auto ABS capital structures. Issuers are better capitalized with more seasoned management teams than they were between 2005 and 2007, and they continue to retain substantial interests in the first loss and bottom classes of their security structures (more than what is required by the Dodd-Frank Act’s risk retention requirements). Additionally, issuers are more liquid now having secured multi-year committed bank warehouse lines allowing them to weather bouts of illiquidity. However, we are at a point in time where credit loss pressure will bring to the fore front comparative issuer profitability, sustainability, and may ultimately be the likely catalyst of a future industry consolidation.
Recently, we have begun to see some of the negative trends in credit abate. Collateral characteristics from late 2016 and early 2017 subprime auto ABS have shown signs that a rationalization in underwriting standards amongst originators has been underway. These recent deals have shown a stabilization of origination volumes, loan terms, lower loan-to-value ratios, and higher pricing, all of which are signs of a tighter credit environment. As long as this trend of stabilizing credit continues, the overall health of the subprime auto industry should remain intact as well as benefit collateral performance in the ABS market.
In sum, the subprime auto industry and its constituent of issuers will undoubtedly continue to attract attention and garner additional media headlines. Navigating this market requires a disciplined approach with specific knowledge and expertise in order to rank each originator by evaluating collateral composition, servicing practices and performance, and deal specific capital structures. With that in mind, we continue to keep a watchful eye on the evolving credit environment; invest with issuers that exhibit steady performance and a willingness to address any deficiencies in their processes, and evaluate each transaction based upon its stand alone credit quality and relative value prospects.