In S&P Global Ratings' opinion, European and U.K. consumer asset-backed securities' (ABS) credit performance and ratings look set to be resilient in the face of cost-of-living pressures, with collateral performance deterioration likely to appear in unsecured and non-prime ABS earlier than secured and prime ABS. To gauge how European and U.K. consumer ABS transactions that we rate are faring, we reviewed their collateral performance, as well as available structural protection to mitigate the impact of any deterioration.

Collateral Performance: Assessing The Potential Impact Of Inflation And Unemployment

In our analysis of the performance of collateral pools backing European and U.K. consumer ABS transactions, we consider a borrower's ability to repay debt as a critical input in determining borrower creditworthiness and the likelihood of default. Given the current deteriorating macroeconomic conditions, two fundamental considerations for this assessment are the impact of consumer price inflation and unemployment rates on the borrower's ability to repay debt. The effect isn't equal across the region--collateral performance will likely differ by country, depending on both the scale of the cost-of-living pressures and the extent of government support measures.

Most ABS sectors continue to exhibit stronger performance than before the COVID-19 pandemic, reflecting low unemployment and the positive impact of the COVID-19 recovery stimuli. However, going into winter, inflation and sustained monetary policy tightening will continue to build pressure on households. We believe that there will be a bifurcation of credit performance between prime and non-prime obligors, and expect only a limited credit impact on prime borrowers given the strong jobs market and some existing, albeit declining household savings. On the other hand, non-prime borrowers--including those on lower incomes--are unlikely to have significant savings and are more vulnerable, as they spend a greater proportion of their income on energy and food items. Therefore, performance for these obligors is likely to deteriorate to a greater extent than for prime borrowers.

Price inflation started to rise in 2021 driven by disrupted supply chains amid rising demand as markets started to recover from the effects of the COVID-19 pandemic. While this continued into 2022, the military conflict in Ukraine has pushed energy and food prices higher, causing a cost-of-living shock to consumers. Continued inflationary pressures may depress household spending power and weaken consumption, while at the same time constrain borrowers' ability to service their debt. Price growth has varied across European nations, partly because of differing household dependence on oil and gas and differences in government support measures. For example, prices in the Netherlands have risen at more than twice the rate of those in France over the past year. National governments have also adopted various policy measures to protect households and businesses from exorbitant energy bills and supply shortages over the winter. These measures range from unit price caps for consumers and businesses, to cuts in VAT and other fuel duties, direct payments and government subsidies, payment deferral schemes, as well as advocating ways to (voluntarily) cut energy consumption. The size of these support programs is significant--on average about 3% GDP on a net basis for EU countries at present prices, and potentially over 9% GDP through 2026 in the U.K. based on recent proposals. The concern for the gilts market in the latter is that nearly all of funding in the U.K. will be via new debt, during a period when the Bank of England is shrinking its balance sheet, and sterling depreciation is adding to inflationary pressures (see "Related Research").

At the same time, although labor market conditions remain tight, real wage growth is negative. As macroeconomic activity weakens, we expect employment growth to soften, and pay growth may not be able to keep pace with inflation until well into 2023. Furthermore, household savings built up during the pandemic are declining: in the U.K. the household savings rate is now very close to the long-term average, falling to 7.6% in second-quarter 2022 from 8.3% the previous quarter. Inflation will continue to squeeze household budgets and potentially affect borrower creditworthiness.

Inflation forecasts continue to be revised higher. We now expect inflation to peak at about 10% and 12% in fourth-quarter 2022 in the eurozone and U.K., and with signs that inflationary pressures are broadening out beyond energy, central banks are eschewing forward guidance in favor of an abrupt tightening in policy. The imperative to raise rates even as growth stalls, albeit with real rates still strongly negative in the near term, will translate to a much tighter financing environment than we have seen in Europe for many years and place additional pressure on household finances (see "Related Research").

In our view, however, the strength of the labor market is the linchpin that will likely determine whether collateral performance normalizes or worsens. We anticipate that unemployment will rise only slightly in 2023 and remain stable across the Eurozone and U.K. to 2025, boding well for ratings migration (see table 1). Most European ABS transactions that we rate are backed by prime borrowers who in many cases have accumulated household savings during the pandemic to manage cost-of-living pressures. Also, a strong jobs market will limit the likelihood of a sharp increase in delinquencies in this segment. Even though households will experience a material decline in buying power, under the circumstances it is still a much better outcome, in relative terms, than a scenario with large-scale unemployment where many households would have to rely on direct and lower government support payments. At the same time, we expect lower income and less creditworthy borrowers to be affected to a much greater extent than prime borrowers by the cost-of-living crisis, despite a strong jobs market.

Table 1

Over the past 20 years, rating movements have shown a 77% negative correlation with unemployment, but limited correlation with inflation (see charts 1 and 2). These effects have typically led to a modest or temporary rise in household expenditure, which most borrowers have been able to accommodate. This time could be different, however, given that the scale of inflationary pressures and the acute pressure on household purchasing power appears significantly larger than at any time in recent history.

Chart 1

Chart 2

Benchmark interest rates have been rising sharply, as central banks tighten monetary policy. Consequently, we expect interest rates on credit cards will also continue to rise. However, products such as auto loans and some other consumer loans generally pay a fixed rate of interest. Therefore, we expect borrowers in existing pools of fixed-rate assets backing European ABS to be less directly affected by rising interest rate rises in the near term. In the longer term, interest rate increases for most types of consumer loans will likely further stretch household finances. Furthermore, borrowers with floating rate mortgages are experiencing an increase in monthly payments, while those on fixed rates will be exposed to payment shocks when their home loans revert over the next few years. Similarly, tenants will potentially face increasing rents as landlords look to pass on higher mortgage payments. These interest rate pressures are occurring against a backdrop of a stagnating macroeconomic environment: we now expect eurozone growth to stall in fourth-quarter 2022 and first-quarter 2023, with growth for the year only reaching 0.3%. The U.K. will suffer a shallow recession, with growth contracting 0.5% in 2023 according to our forecasts (see "Related Research").

Auto Loans

We classify most borrowers in our rated U.K. and European auto ABS universe as prime. Therefore, we expect the underlying obligors to be in a stronger position to pay their outstanding auto loans. Overall arrears in prime auto ABS transactions have remained low and stable at about 1% since late 2021, while severe delinquencies (90+ days delinquent) have recently trended lower than 0.2% (see chart 3).

Chart 3

Furthermore, U.K. prime transactions typically comprise mainly personal contract purchase (PCP) loans, and we also rate several European auto lease transactions. In such transactions, residual value (RV) risk, which arises if the liquidation proceeds from the sale of the vehicle are lower than the securitized value and are therefore associated with secondhand car values, generally affects the required levels of credit enhancement to a greater extent than our default assumptions. The post-pandemic used car market in Europe was remarkably strong but is now under some pressure because of rising inflation and declining consumer confidence. Due to recent surging prices, consumers are assessing the value of buying a used car at high price points and in some cases, may hold onto their existing vehicles or use other forms of transport as an alternative. Although used car prices may decline moderately in some countries in 2023, we do not expect them to fall significantly. Given this outlook, we believe that ratings will remain relatively stable for transactions that are exposed to RV risk. Transactions with no RV exposure are likely to be more affected by the current cost-of-living crisis as the transaction performance is linked to a greater degree to the strength of the underlying borrowers' creditworthiness and their ability to stay current on the loan.

At the same time, we believe that lower credit quality borrowers will be more sensitive to the current cost-of-living pressures. We continue to track various potential early performance indicators for Auto ABS, and have reviewed early delinquencies, i.e., less than 60 days delinquent, across prime and near-prime transactions we rate, since we consider them to be early indicators of potential performance deterioration. While most of the 0-30 days delinquencies could be technical, they have increased steadily since the start of the year for near-prime transactions we rate compared to steady levels in prime transactions (see charts 4 and 5).

Chart 4

Chart 5

However, 60+ days delinquencies or roll-over rates in these transactions have not deteriorated significantly. This is most likely due to timely servicer interventions to work out payment plans and limit arrears for borrowers hit by the cost-of-living crisis, gaining from the servicing experience during the pandemic. We expect that servicers' proactive measures, specifically for pools comprising loans to more vulnerable or near-prime borrowers, may help limit the magnitude of collateral performance deterioration.

In our view, our stresses relating to the likelihood of default sufficiently capture a potential deterioration in collateral performance and the impact of rising interest rates on the rated notes. In auto ABS structures, the underlying receivables typically pay a fixed rate of interest, whereas the coupon on the liabilities is floating. An interest rate swap or cap is usually included to mitigate the impact on note coupon payments from rising interest rates on the index they are linked to. Moreover, should the underlying collateral pool's performance deteriorate, the available credit enhancement and liquidity coverage in the transactions we rate provide significant mitigation, in our view.

Credit Cards

We will continue to track various potential early performance indicators for credit card ABS including payment rates and utilization rates, and early delinquencies that could signal borrowers may face pressure in the months ahead. However, to date the performance data for the transactions we rate have not shown any material performance deterioration. This likely reflects the strong labor market, which means that while still employed, some highly indebted borrowers retain the ability to adjust their spending patterns to cope with rising inflation and interest rates.

Given our macroeconomic outlook and the levels of cushion within our base-case assumptions, we do not believe that any revisions to our base case assumptions are warranted at this time. Therefore, we currently believe that our ratings on U.K. and European credit card ABS transactions will remain stable. If we were to revise our base-case assumptions following deteriorating performance or a revised economic outlook, we anticipate that speculative-grade ratings would be more sensitive to these changes.

Unlike auto loans, credit cards are unsecured assets. We analyze credit card ABS transactions based on three key performance variables: charge-offs (defaults), yield, and payment rate. A positive movement in one of these variables may offset any adverse movement in another. For example, an increase in the yield may mitigate a reduction in the payment rate or an increase in the charge-off rate. Nevertheless, we foresee portfolios with lower credit quality borrowers experiencing greater performance deterioration (i.e., higher charge-offs, lower payment, or lower yield) than prime transactions.

In the U.K., annual credit card borrowing increased in August 2022 at the fastest annual rate since 2005 according to the Bank of England. Consumers borrowed an additional £500 million on their cards, an increase of 12.9% on the August 2021 figure, reflecting the impact of significant inflationary pressures on household budgets. This growth is set to continue as increasing numbers of people use credit cards to pay bills and cover essential spend. However, we also expect to see declining card usage for discretionary purchases by convenience users. We have undertaken outreach meetings with credit card originators who have informed us that although some are tightening their underwriting criteria to reflect inflationary pressures and proactively contacting borrowers who are deemed at risk of experiencing affordability issues, they are not observing increases in delinquencies and utilization rates or a decline in payment rates. These trends, which indicate that performance is currently relatively stable, are also reflected in the investor reports for the credit card transactions that we rate.

Charge-offs (defaults)

The likelihood of obligors not satisfying their credit card payment obligations will depend on their employment status, and how much their real income falls due to rising prices and rising interest rates. While all credit or risk tiers will likely be affected by rising inflation, in our view, prime borrowers may have more financial resources to draw upon to cover current cost-of-living pressures than lower credit quality borrowers. We view most borrowers in rated U.K. and European credit card ABS transactions as prime, and as a result, the underlying obligors should be in a stronger position to pay their outstanding credit card debt.

Rising delinquencies are early indicators of potential defaults, and prime and non-prime credit card transactions' collateral performance has not materially declined so far (see "Related Research"). For example, in our U.K. credit card ABS index, very early (or 0-30 day) delinquencies have remained stable at approximately 2.5% for the non-prime transaction we rate (Oban Cards 2021-1 PLC) and at about 0.10% for prime transactions (see chart 6).

Chart 6

Our base-case assumptions reflect our view of expected performance during multiple economic scenarios and forecasted economic variables such as unemployment levels and bankruptcy rates. Current levels of strong performance remain below our base case, so any deterioration may still remain within our initial expectations. In addition, under the current expected levels of credit stress, our view of 'AAA' charge-offs for each issuer remains stable, ranging from 30.6%-75.0% for U.K. issuers and 16.8%-42.3% for European issuers (see tables 3 and 4 in the appendix for issuer-level information).

Payment rates

Given the cost-of-living pressures, we expect payment rates to moderate as convenience users reduce their spending activity and postpone nonessential purchases.

Our base-case payment rate assumptions are generally below the current performance (see tables 5 and 6). When sizing our base-case assumptions, we consider a reduction in convenience users in the pool during adverse scenarios. For U.K. issuers, our stressed payment rate assumptions reflect that low payment rates from balance transfers during the promotional period could mitigate a deteriorating payment rate in an amortization scenario once the promotional periods expire. For receivables in France and Spain, we typically model the stressed payment rate at the minimum levels required by law.

Yield

We typically assume that yield is below the issuers' current performance (see tables 7 and 8). For U.K. issuers, our stressed yield assumptions reflect that the high proportion of balance transfer receivables would begin to accrue yield if the obligors do not fully repay their balances once the promotional periods expire. Our base-case yield assumptions also do not give credit to interchange fees. Therefore, even if purchase rates decline, we do not believe the resulting reduced interchange fees would affect our base-case assumptions.

Table 2

As indicated in table 2, our base-case assumptions for the key performance variables generally incorporate a cushion when compared with the current performance to account for potential migration of the portfolio during the transaction's revolving period. They also reflect our view of expected performance during multiple economic scenarios and forecasted economic variables such as unemployment levels and bankruptcy rates. As a result, given our current macroeconomic outlook for the impact of the cost-of-living crisis, even if transactions experience temporary credit stress, our view is that performance will remain within our base-case expectations.

Structural mitigants

Compared to auto ABS transactions, credit card issuers also benefit from a significant amount of excess spread, which they may use to satisfy temporary delays in collections on some of the securitized receivables. Currently, the issuers we rate have robust excess revenue collections (i.e., yield net of charge-offs) to offset any increase in delinquencies (see tables 9 and 10). In addition, if interest collections are insufficient to pay bond coupons, many credit card issuers can reallocate principal collections.

Issuers may also have funded cash reserves that they can draw upon if collections are insufficient to cover timely interest (see tables 11 and 12).

In our stressed rating analysis, we determine the maximum purchase rate credit based on the originator rating. If the originator's credit quality deteriorates, we may lower the purchase rate credit, which could result in negative rating actions across the capital structure absent any mitigating factors such as excess credit enhancement. In U.K. and European transactions where we give credit to purchase rate, most of the originators benefit from stable rating outlooks or could withstand downgrades of several notches before we would reduce our purchase rate assumptions.

Appendix

Charge-off rate cushion

Table 3

Table 4

Payment rate cushion

Table 5

Table 6

Yield cushion

Table 7

Table 8

Liquidity coverage

Table 9

Table 10

Cash reserve

Table 11

Table 12

Related Research

• United Kingdom Outlook Revised To Negative On Rising Fiscal Risks; 'AA/A-1+' Ratings Affirmed, Sept. 30, 2022
• Credit Conditions Europe Q4 2022: Hunkering Down For Winter, Sept. 27, 2022
• European Auto ABS Index Report Q2 2022, Aug. 2, 2022
• European And U.K. Credit Card ABS Index Report Q2 2022, Aug. 2, 2022