Key Takeaways
- U.S. prime and subprime auto loans, leases, and equipment ABS new issuance spreads have fallen to or below their pre-market dislocation levels.
- Subprime auto ABS new issuance spreads for 'BB' to 'B' rated classes--although significantly lower than the wide levels reached in second-quarter 2020--are now at or marginally wider than their pre-market dislocation levels.
- We believe these declines in new issuance spreads signal the market's views on risk premium, though unemployment and inflation are key risks that will continue to influence market sentiments.
New issue spreads for U.S. subprime auto loans, prime auto loans and leases, and equipment asset-backed securities (ABS) issued in first-quarter 2021 fell to or below their first-quarter 2020 pre-market dislocation levels. These spreads had increased last year amid the tide of uncertainty that followed the onset of the COVID-19 pandemic and the general market dislocation. S&P Global Ratings believes the decline in new issue spreads is a strong signal of the market's view on consumer related risk premium in general. The lowering of risk expectation and search for yield also contributed to spread compression. The market perceives that risks persist in the most subordinated rated classes, particularly in subprime auto ABS. Despite declining from the elevated levels, these classes' spreads are now at or wider than pre-pandemic levels.
Investment-Grade Spreads Decline To Pre-Pandemic Levels
We reviewed new issuance from rated auto ABS issuers that maintained regularly quarterly issuances in 2020, controlled for size (liquidity risk) and weighted average life (term risk). Our analysis indicates that new issue spreads for "A-stack" issuances (class A debt with ratings in the 'AAA' through 'A' rating categories) and "B-stack" issuances (class B debt with ratings in the 'BBB' through 'B' rating categories) have returned to their pre-pandemic levels.
The sampled prime auto loan ABS new issue transactions revealed that new issue spreads for class A-2 (rated 'AAA'), class A-3 ('AAA'), class A-4 ('AAA'), class B ('AA'), class C ('A'), and class D ('BBB') notes were lower, on average, by 106 basis points (bps), 102 bps, 129 bps, 198 bps, 295 bps, and 450 bps, respectively, in first-quarter 2021 compared with the second-quarter 2020 market dislocation levels. Measured against new issue transactions in first-quarter 2020, before the market dislocation, new issue spreads for classes A-2, A-3, A-4, B, C, and D were lower, on average, by 12 bps, 16 bps, 21 bps, 19 bps, 8 bps, and 15 bps, respectively, as of first-quarter 2021 (see chart 1).
For prime auto lease ABS, new issue spreads have not only recovered from the elevated levels reached in second-quarter 2020 but are below the pre-market dislocation levels. New issue spreads for classes A-2, A-3, A-4, B, C, and D were lower, on average, by 14 bps, 18 bps, 20 bps, 17 bps, 15 bps, and 15 bps, respectively, as of first-quarter 2021 compared with the first-quarter 2020 pre-market dislocation levels (see chart 2).
Similarly, for the new issue transactions from two established large-ticket equipment ABS issuers, the new issue spreads for classes A-2, A-3, A-4, B, C, and D were lower, on average, by 17 bps, 27 bps, 45 bps, 28 bps, 12 bps, and 13 bps, respectively, compared with the first-quarter 2020 (see chart 3).
Chart 1
Chart 2
Chart 3
Subprime ABS Spreads Show Some Risk Differentiation
Our analysis of a sample of three established subprime auto ABS issuers revealed that new issue spreads for class A (rated 'AAA'), class B ('AA'), class C ('A'), and class D ('BBB'/'BBB-') notes were lower, on average, by 96 bps, 170 bps, 280 bps, and 430 bps, respectively, in first-quarter 2021 compared with second-quarter 2020. When measured against the subprime transactions issued in first-quarter 2020 before the market dislocation, new issue spreads for class A, B, C, and D issuances have declined by approximately 13 bps, 21 bps, 22 bps, and 23 bps, respectively, as of first-quarter 2021. However, spreads on the lower subordinated classes, class E ('BB-') and class F ('B'), are either unchanged or marginally wider than their first-quarter 2020 pre-market dislocation levels, despite having recovered since second-quarter 2020 (see chart 4).
Chart 4
Three Key Factors Drive Lower Spreads
We believe the tighter spreads across the A-stack classes and the unchanged to wider spreads on the 'BB-' and 'B' rated B-stack classes are attributable to several factors, including the following:
- Reduced uncertainty. The market's initial negative view of the pandemic's impact on consumers and business credit resulted in a risk premium that was priced into new issuance spreads. However, the fallout was tempered by various government assistance programs, extended employment benefits, and issuers' forbearance programs. Commercial equipment ABS also benefited from increased demand for technology to support widespread remote working, government assistance to the agriculture industry, and commodity price increases. Meanwhile, ABS auto loans and leases also benefitted from the robust resale prices for vehicles, which supported vehicle recovery and residual values. We believe the tighter spreads (lower risk premia components) reflect the $1.9 trillion COVID-19 Relief Bill's tempering effect on consumer stress. As a result of these factors, the uncertainty risk abated and the associated spread premium declined.
- Risk differentiation. With new issue spreads declining or tightening to or below pre-market dislocation levels for the senior 'A' rated classes, the market is signaling less concerns about the likelihood of credit risk migrating up the credit stack. Nevertheless, the market perceives that risks persist in the most subordinated 'BB' and 'B' rated classes, particularly in subprime auto ABS. These classes' spreads and associated risk premiums, while improving, are now at or marginally wider than pre-pandemic levels.
- Yield pickup. Investors' search for yield increased amid the pandemic as Treasury and swap yields (the benchmark against which ABS is priced) declined due to flight-to-quality, near-zero interest rate policy, and quantitative easing measures (see charts 5 and 6). As the risk premia associated with the market dislocation continues to wane, increased demand for higher yielding ABS also contributed to new issuance spread compression.
Chart 5
Chart 6
Cost Of Debt Falls To Historical Lows
The compression of ABS spreads and the decline in swap yields have resulted in lower coupons and historically low cost of debt for issuers, despite the market dislocation. For instance, the cost of debt for subprime auto loan ABS initially increased to about 3.57%-4.12% immediately after the market dislocation from about 2.28%-2.64%. However, by March 2021, subprime auto loan ABS cost of debt had fallen below pre-market dislocation levels to 0.92%-1.15% (see chart 7). Prime auto loan ABS cost of debt fell to 0.26%-0.43% in first-quarter 2021 from 1.88%-1.97% pre-pandemic (see chart 8). Similarly, auto lease and equipment ABS cost of debt fell to 0.31%-0.35% and 0.45%-0.49%, respectively, from 1.75%-1.95% and 1.86%-2.04% (see charts 9 and 10).
Chart 7
Chart 8
Chart 9
Chart 10
Unemployment And Inflation Remain Key Risks
We believe the decline in ABS new issue spreads from the highs reached following the market dislocation in 2020 is a strong signal of the market's view on consumer risk premium. However, we also believe that unemployment and inflation remain key risks that will continue to influence market sentiment (see "Orderly Global Reflation Will Support The Recovery From COVID-19," March 22, 2021). Unemployment levels continue to decline from pandemic-induced highs, but there is some angst about the true level of unemployment and the labor participation rate. Anecdotal evidence indicates that many people have exited the labor force after unsuccessful attempts at finding jobs, and this is not reflected in the unemployment rate. Meanwhile, inflation expectation, based on the recent increase in the two- to 10-year treasury yield differential and the upward tilt of the treasury yield curve, could influence cost of debt levels.
S&P Global Ratings believes there remains high, albeit moderating, uncertainty about the evolution of the coronavirus pandemic and its economic effects. Vaccine production is ramping up and rollouts are gathering pace around the world. Widespread immunization, which will help pave the way for a return to more normal levels of social and economic activity, looks to be achievable by most developed economies by the end of the third quarter. However, some emerging markets may only be able to achieve widespread immunization by year-end or later. We use these assumptions about vaccine timing in assessing the economic and credit implications associated with the pandemic (see our research here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.
Editor: Georgia Jones
This report does not constitute a rating action.
| Primary Credit Analyst: | Sanjay Narine, CFA, Toronto + 1 (416) 507 2548; sanjay.narine@spglobal.com |
| Secondary Contact: | Frank J Trick, New York + 1 (212) 438 1108; frank.trick@spglobal.com |
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