Demystifying European Asset Backed SecuritiesNovember 2016

For UK professional clients only2

Our team of 40 staff consists of 19 investment professionals with on average 18 years’ experience. They are led by twelve partners who each have a significant stake in the business and on average, 23 years’ investment experience. Our team members hail from a wide variety of fixed income disciplines. These include working in portfolio management, banking, trading and rating agencies, which gives us a more holistic view of the market. Our team remains close to the market by conducting their own trading. We consider this to be vitally important in a world where liquidity and trading costs are key concerns.

TwentyFour is a leader in the ABS industry, with nine investment professionals. This represents one of the largest pools of talent in the industry dedicated to European ABS. TwentyFour’s experience in ABS goes back a long way – to 1989 when Rob Ford, then at Barclays Bank, issued the first European securitisation. Prior to joining TwentyFour Asset Management, Ben Hayward and Eoin Walsh managed Europe’s largest ABS funds. TwentyFour went on to launch the first dedicated retail RMBS fund in 2009 and then launched the first dedicated listed European ABS fund in 2013.

Since its foundation in 2008, TwentyFour and the ABS team have won numerous awards and regularly train and advise sovereign institutions on fixed income and ABS. Our partners also participate in industry and regulatory bodies to set standards and improve market liquidity.

We are fixed income specialists – it is the only asset class we cover. Our focus is on preserving our investors’ capital and taking advantage of capital growth opportunities in the right market conditions.

For UK professional clients only 3

Figure 1: ABS issuance and cash flows

Demystifying European Asset Backed Securities

Income is hard to come by these days. Ultra-low interest rates have meant that previous sources of income have become increasingly elusive. That is why asset backed securities (ABS) – once shunned in the wake of the financial crisis – are now back in favour. They are one of the few types of bonds which are able to deliver an attractive return today.

This is particularly true for Europe, whose ABS market is characterised by solid fundamentals, high underwriting standards and attractive spreads. It’s an under-researched area of the market, providing good opportunities for income-seeking investors.

In this paper, we will try to demystify European ABS. First we explain

how ABS work, their investment characteristics and how European

ABS differ from both US ABS and senior loans. We then go on to

discuss how European ABS can fit into a fixed income portfolio and

why it’s an attractive investment.

HOW ABS WORKABS are backed by a specific pool of financial assets. For instance,

these can be credit card loans, auto loans or mortgage loans. Just

like corporate bonds they pay interest periodically on a defined

basis. The difference is that these interest payments are not usually

fixed rate. They typically offer a margin over a floating rate index

such as 3 month GBP LIBOR or 3 month EURIBOR – the rates

that banks lend to one another. However, just like all fixed income

products, they pay the principal back at maturity.

A special purpose vehicle (SPV) is the legal entity used to issue

ABS bonds, also known as securitisation. The SPV buys a pool of

loans or other assets from a financial institution, such as a bank or

building society. The SPV then issues bonds to end investors. Then

the underlying assets in the pool pay the coupon on the bonds (See

Figure 1 below). These bonds are known as Asset Backed Securities

or ABS because they are secured on the specific pool of collateral

held by the SPV.

WHY ISSUE ABS?ABS are typically issued as a funding tool for the sponsoring entity.

For example, a bank will issue mortgage backed securities to fund a

specific pool of mortgages. In limited scenarios the sponsor will be

able to claim capital relief, provided the sponsor can meet certain

accounting and risk-transfer conditions, although following changes

to regulations in recent years this is rare.

As ABS are generally only used as a funding tool, they make up

part of the sponsoring entity’s treasury funding options. For a bank,

ABS can sit alongside deposits, covered bonds, senior debt and other

bonds as a way of obtaining leverage on their capital.

AT A GLANCE• ABS are mainly floating rate securities, which have near-

zero interest rate risk.

• ABS provide higher yields than traditional fixed income

instruments for a given rating.

• They are issued by financial institutions as a treasury

funding tool and in some cases can offer capital relief.

• ABS enable investors to gain exposure to a pool of specific

assets and are structured to provide attractive defensive

risk characteristics.

• European ABS are fundamentally different to US ABS,

with higher lending standards, and recourse to the

original borrower. Historically, expected cumulative

lifetime loss rates are 1.0% for the entirety of European

ABS, whereas US loss rates are 7.3%.¹

• ABS offer significant advantages over senior secured

loans, with collateralised loan obligations enabling higher

yields with lower risks than similar senior secured loans.

• It is an opportune time to invest in ABS, given attractive

yields, improving fundamentals, limited supply and

potential for capital gains if spreads tighten.

Sponsore.g. Bank A

SPVBank A Mortgages

2016-1

ABSInvestors

IssuesABS

Sellsloans and assets

Buys ABSABS issuance proceeds

1 Structured Finance Losses 2000-2014, Fitch Global, 7th February 2015

For UK professional clients only4

Figure 2: Different types of ABS

There are many different types of ABS that investors can choose from,

backed by different types of assets with slightly different characteristics.

Some of these differences are highlighted below in Figure 2.

Yield and risk characteristics of each type of ABS vary widely

depending on the combination of underlying assets, rating, collateral

and structure so it is difficult to provide general ranges per type

of ABS. That said, as an illustration, at the tight end of the market

both Dutch triple-A prime mortgage ABS and German triple-A auto

loan ABS are trading at around 20-30bps over EURIBOR, whereas

single-A rated CLOs and prime RMBS offer spreads around 320bps,

rising to 500-700 bps as ratings reduce to double-B.3

Note that although the rest of the paper uses examples involving

RMBS, the principles outlined apply to all of the above types of ABS.

WHAT DO THESE ABS ASSET POOLS LOOK LIKE?They typically focus on assets from a:

• Single geography i.e. the Netherlands or Spain

• Single type i.e. residential or commercial mortgages

• Single originator i.e. a bank such as Santander or Barclays

The exceptions here are CLOs and CMBS where a blending of

geographies may occur.

Another key difference to other asset classes is that ABS issuers

produce reports which show how loans within each of their pools are

performing. This enables experienced managers to accurately analyse

and value ABS, as well as enabling ABS buyers to ensure they only gain

exposure to the specific markets and assets, thus avoiding exposure to

segments and assets perceived as undesirable by the manager. ABS

is a niche, complex sector and therefore not highly researched, which

enables expert managers to consistently find value.

WHAT DOES THE CAPITAL STRUCTURE OF A TYPICAL ABS LOOK LIKE?ABS deals typically issue multiple bonds that are tranched into different currencies, maturities and most significantly, seniority. This is the key difference between ABS and other structures. It means that the cash flows from the underlying asset pool is used to pay the ABS tranches in turn, from senior to junior. Thus the cash flows appear to flow down the ABS structure, as shown in the diagram (Figure 3) overleaf. Similarly, defaults flow up the structure.

This pooled structure means that the risk associated with

holding a given tranche of ABS depends primarily on the quality of

the collateral and the probability of default in the underlying asset

pool. If there are defaults then the seniority of the tranche in the

ABS structure comes into play. Thus, senior ABS at the “top” of a

structure may be rated triple-A, while the more junior mezzanine

tranches may be rated double- or single-B.

To compensate investors for the risk they take, junior tranches

will offer higher returns than more senior tranches. An investor can

then purchase the tranches they need to satisfy their appetite for

risk and yield.

In addition, ABS investors benefit from three types of protection.

Figure 3 overleaf explains how this works using residential

mortgage-backed securities as an example. A similar approach is

used across other types of ABS, wherever the ABS is secured on an

asset, such as Auto loans or Commercial Real Estate transactions.

For unsecured lending such as credit card receivables the borrower

equity concept does not apply.

Type Description Volume2

Residential mortgage backed

securities (RMBS)

RMBS are pools of mortgage loans created by banks and

other financial institutions. They represent the largest component of

the European ABS market and are the most liquid.

€ 910 bn

Consumer receivables

Consumer receivables include a large variety of unsecured

consumer debt types that have been securitised including auto loans,

credit card receivables and unsecured personal loans.

€ 230 bn

Commercial mortgage backed

securities (CMBS)

CMBS are mortgage-backed securities backed by commercial

mortgages rather than residential mortgages. CMBS use structures

similar to other forms of ABS.

€ 95 bn

Collateralised loan obligations

(CLOs)

CLOs are pools of corporate loans, refinanced in a securitised

structure. These can either be static pools from a bank balance sheet

or a managed product run by a specialist loan manager.

€ 60 bn

Total € 1.4 tn

2 Securities Industry and Financial Market Association as of end 2015, TwentyFour Asset Management. Note definition of each market segment is not precise and differs between market data providers.

3 TwentyFour Asset Management as of June 2016. See Figure 8 for further details.

For UK professional clients only 5

1. HOMEOWNER EQUITYThe first loss is absorbed by the home owner’s equity in the

property. In our example above, this amounts to €280 million or 28

percent. In other words, before ABS bondholders suffer any losses,

three things would need to happen: on average house prices would

have to fall more than 28 percent, homeowners would need to

default and the other protections mentioned below would need to

be exhausted.

2. EXCESS INTERESTThis is the interest in excess of what is needed to pay the coupons

on the ABS, represented by the white box in the diagram above. It

normally goes to the issuer of the ABS. However, if there is a loss on

the sale of a defaulted property, this excess interest from the rest of

the performing mortgage pool covers the loss. Therefore, it provides

additional protection for the bondholder and helps to align the

interest of the bondholder and issuer.

3. RESERVE FUNDThis is a cash account set up by the bond issuer. It acts as a further

cushion for protection and can be drawn down to offset losses.

Once these three layers of protection are exhausted, losses are

allocated to the most junior tranches. In the diagram above, the first

tranche is rated double-B. The tranche has to be written down to

zero before losses are recorded in the next tranche, rated triple-B.

This affords additional protection for ABS in more senior tranches,

such as those rated triple-A. Collectively these three layers of

protection plus tranching provide “credit enhancement”.

ABS risks also reduce with time. Firstly, as the loan is paid down

the outstanding principal is reduced. Secondly, rising asset prices

improve the collateral’s value. The same is also true for the ABS

deals themselves. As the underlying asset pool is amortised (through

prepayment, maturity or even the gradual amortisation through

scheduled monthly repayments), the relative size of the protection

layers generally increases: junior tranches, home owner’s equity and

the reserve fund.

LET’S REITERATE THE BENEFITS OF EUROPEAN ABS:• Bankruptcy remote: The assets sit within a segregated legal

entity – the SPV – protecting them from outside events such as

bankruptcy of the sponsor.

• Direct recourse: They are backed by specific asset or loan

pools, where the coupons and principal are generated by the

underlying assets.

• Built-in loss protection: They are structured into multiple layers

of risk – once credit enhancement is exhausted, junior tranches

take losses before more senior ones.

• Highly granular: They are geographically diverse, containing

thousands of real economy assets such as residential mortgages,

auto loans, credit cards or SME loans.

• Highly transparent: They offer detailed and frequent reporting,

thereby enabling investors to conduct quantitative and

qualitative research.

• Alignment of interest: The issuers are required by regulatory

authorities to retain “skin in the game”.

HOW EUROPEAN ABS DIFFER FROM US ABSAlthough they share the same acronym, European ABS are not

the same as their US counterparts. European ABS have distinct

differences making them more investor friendly, with a much better

track record.

These differences include:

1. Higher lending standards – The lending standards for European

residential mortgage backed securities are generally higher

than their US counterparts as borrowers are required to hold

significant equity in the property and demonstrate proof of

income before loans are granted. Unlike in the US, there is no

true “sub-prime” market in Europe. In the US, the RMBS market

predominately focuses on “sub-prime” because the prime market

largely conforms to agency lending standard i.e. those set by

Fannie Mae and Freddie Mac.

RMBS: A Sample Structure

€1bnproperty pool €720m

mortgagepool

AAA Notes

AA Notes

A Notes

BBB Notes

BB Notes

Reserve Fund

Excess interest

Mortgages

Interest &Principal

Total NotesIssued €720m

Home owner’s equity:absorbs first loss Further losses

For UK professional clients only6

Figure 3: Example ABS capital structure

2. Alignment of Interest – In the majority of deals in the European

ABS market, the first loss piece is retained by the issuer of

the ABS. Historically, in most US RMBS all the risk was fully

transferred from issuer to the bondholder, encouraging the

issuer to focus on increasing volume to earn origination fees

rather than maintaining quality.

3. Recourse – The US mortgage market is a non-recourse market,

so the property is the only way of mitigating a loss in a default

scenario. This means that borrowers in default can hand the keys

for a property back to the bank with no threat of further action

to enforce repayment. In European mortgage markets, the lender

can continue to pursue borrowers for recovery after default for a

multi-year period. This has a material impact on the post-default

life of the borrower, creating a more powerful obligation to pay.

This has led to much lower default rates in comparison.

ADVANTAGES OVER SENIOR SECURED LOANSSenior secured loans are loans made to corporates, typically of

sub-investment grade, which will be originated by banks but may be

syndicated to investors. These loans are secured on the assets of the

corporate. CLOs are then bonds which are backed by senior secured

loans, which gives the CLOs attractive ABS characteristics. Here we

compare senior secured loans to ABS because both fit into clients’

alternative allocations and can fulfil similar client needs. However,

ABS offer significant advantages over the loan market:

• Larger: The European ABS market at about € 1.4 trillion is far

larger and more liquid than the loan market, which is only around

€100 bn5, making it less suitable for institutional investment.

• More choice: Loan issuers are typically sub-investment grade,

whereas ABS offers a wide range of credit ratings from triple-A to

unrated.

• Greater diversification: ABS are structured with loss-absorbing

characteristics and pool risks across a diverse set of many

loans, meaning that large-scale defaults and reductions in

property value are needed to cause losses to investors. In

contrast, senior loans depend on individual companies’ ability

to make repayments, meaning that one default can result in

losses for investors.

• Diverse exposures: The loan market contains purely corporate

exposure, whereas ABS enables exposure to corporate and

consumer lending.

• Better risk-return: The European ABS market has a lower

default and loss rate than the European loan market, plus

European ABS offers a higher yield on a comparable rating basis.

Rather than making a direct investment in a senior loan, the loan

market can be accessed via the CLO market with better yields and

typically more defensive characteristics.

For UK professional clients only 7

5 Credit Suisse Institutional Western European Leveraged Loan Index, June 2016.

Europe and US are Different

Majority of RMBS Originated by Banks ✓ ✗

Generally Higher Lending Criteria ✓ ✗

Historical Use of Affordability tests ✓ ✗

Typically Recourse Lending ✓ ✗

Personal Stigma of Insolvency ✓ ✗Banks Generally Service

Securitised Assets ✓ ✗

Banks Typically Retain First Loss ✓ ✗

Cumulative expected lifetime loss rate4 0.3% 8.1%

Figure 4: Differences between European and US RMBS

4 RMBS Losses 2000-2014, Fitch Global, 7th February 2015

ADVANTAGES OF INCLUDING EUROPEAN ABS IN A PORTFOLIOEuropean ABS can add diversity to a fixed income portfolio, as well

as providing additional yield.

ABS is probably the most flexible part of the fixed income

universe, offering the ability to invest across the full spectrum of

ratings from triple-A to single-B and even unrated. By selecting

bonds carefully, a highly liquid profile can be created, or alternatively

a yield premium can be earned for less liquid positions.

With current yields ranging from EURIBOR plus 25bps

(effectively a zero yield) to the low double digit (11 percent yield in

May 2016), a risk-return profile, with a specific liquidity focus and

sectoral and geographical limits can be created for a wide range of

purposes and types of investor.

TwentyFour Asset Management currently runs mandates that

range from high quality investment-grade, to mixed investment-

grade and sub-investment grade funds that are seeking to maximise

income and capital growth. Therefore, the strategies we manage

can be compared with cash, sovereign bonds, senior secured loans,

corporate bonds and high yield bonds, but typically offer a better

risk-return profile.

Broadly speaking, our ABS products can be compared with the

following traditional asset classes, when considering the return

offered rather than other fundamental characteristics:

• An enhanced cash strategy – Cash and money market

investments

• An investment grade strategy – Corporate bonds

• A higher yield strategy – Strategic bonds, high yield bonds and

hedge funds

UNDERSTANDING THE RISKSIt is possible to classify risk on a basic level into credit risk (as

denoted by rating), interest rate risk (duration) and spread volatility

(credit spread duration and historic volatility).

Credit risk in ABS varies according to the rating of the instrument

and the rating is driven by a number of fundamental characteristics

of the security e.g. the quality of the collateral, the defensiveness

of the structure and the geography. Ratings are independently

determined by agencies such as Standard and Poor’s, Fitch and

Moody’s, based on a detailed assessment of these factors. In

Europe these ratings have proved reliable. Even during periods of

market stress such as the 2008 financial crisis, very low default rates

were observed.

The key difference to other types of fixed income investment

is that interest rate risk is minimal as the vast majority of

European ABS are floating rate.

There are no indices for European ABS, therefore it is difficult to

track volatility for segments of the market. Instead, we can compare

the volatilities and risk characteristics of the different TwentyFour

strategies in figure 5.

All of TwentyFour’s strategies are diversified across the different

types of ABS with the sector analysis designed to provide a risk-

return-liquidity profile in line with the fund’s stated aims. In general

the enhanced cash strategies’ contains higher rated instruments,

while the higher yield strategy focused on less liquid instruments.

Figure 6 shows that TwentyFour’s ABS portfolios offer higher

yields than traditional fixed income investments, even though they

invest in higher-rated assets.

For UK professional clients only8

Figure 5: Risk characteristics of European ABS

6 Interest rate duration: Sensitivity of returns to changes in interest rate7 Credit duration: Sensitivity of returns to changes in credit spreads8 Gross yield of a bond is the return a bond earns on the price at which it was purchased if held to maturity. The stated gross yield is calculated at fund level and

the EUR and GBP gross yields calculated by adjusting for the relevant libor rates on each bond, as appropriate

Strategy type Weighted average Historical

default rate

3-year

volatility

Gross yield8 Liquidity

Rating Interest rate

duration6

Credit

duration7

GBP GBP

TwentyFour

Enhanced

Cash Strategy

AAA

Floating rate,

so close to

zero

2.1yrs

None since

inception

0.51% 1.12% High

TwentyFour

Investment

Grade Strategy

AA- 3.5yrs 2.41% 3.47% High

TwentyFour

Higher Yield

Strategy

BBB 4.1yrs 5.36% 8.13% Medium

Source: TwentyFour Asset Management, 31 May 2016

For UK professional clients only 9

MARKET OUTLOOKEuropean ABS offer attractive yields, improving fundamentals, limited supply, and potential for capital gains through tightening spreads:

1. Attractive yields: Figure 7 below shows that for any given rating, ABS offers a higher yield than traditional fixed income.

Note that Consumer Receivables is not included below as data is sparse and focused on the higher ratings buckets. As an example,

triple-A German Auto loans currently offer yields of around 20-30bps over EURIBOR.

Figure 6: Yields and ratings of TwentyFour ABS strategies versus traditional indices Source: Bloomberg, June 20169

Figure 7: ABS and corporate spreads by rating and asset class Source: TwentyFour Asset Management, Barclays June 2016

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TwentyFourInvestment Grade ABS

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Investment GradeCredit Index

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US HighYield Index

Past performance is no indication of current or future performance

AAA AA A BBB BB BPrime RMBS 80 250 320 400 525Buy To Let RMBS 135 245 305 445Near Prime RMBS 150 285 380 450CMBS 128 220 285 375CLOs 151 220 325 450 740 1100Euro Corps 24 38 95 155 338 602£ Corps 42 80 147 221 414 630$ Corps 81 70 113 203 385 595

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2. Improving fundamentals: The credit risk of European ABS has

also been improving thanks to falling unemployment (Figure

8) and a recovering housing market (Figure 9) in the markets

with greatest RMBS issuance volumes. ABS has performed

consistently well through a number of market cycles including

the recent financial crisis. During the depths of the financial crisis,

European ABS outperformed other asset classes from a default

and a loss point of view. As such, Brexit is not expected to present

significant challenges to fundamental performance.

3. Limited supply: Traditional ABS issuers have always had a

number of sources of funding ranging from retail client deposits

to equity issuance. However, with the readily available supply of

cheap funding from central banks, new ABS issuance has

dropped materially. While there have been the odd periods of

oversupply due to market technicals, this dynamic of low supply

will support price performance due to the scarcity of product.

4. Potential for capital gains: Markets have been slow to bounce

back from the volatility seen in during the first quarter of

2016, creating significant value against long run averages and

alternatives. Figure 10 shows that CLO spreads in most market

segments remain above their long-term averages, despite

volatility returning to normal. If spreads tighten, CLO owners will

make capital gains.

Figure 8: Unemployment rates in Europe, % Source: Bloomberg, June 2016

Figure 9: House Price Index, Year on Year change, % Source: Bloomberg, June 2016

For UK professional clients only10

For UK professional clients only 11

CONCLUSIONABS are mostly floating rate securities, which have minimal

interest rate risk. They provide higher yields than traditional

fixed income instruments for a given rating. They are structured

to provide credit enhancement and attractive defensive risk

characteristics, partly through pooling of assets and tranching of

bonds, and partly through other credit enhancement techniques.

Highly transparent reporting means that experienced managers are

able to gain exposure to pools of specific assets and find value within

this under-researched segment.

European ABS are fundamentally different to US ABS, with

higher lending standards, a greater alignment of interests with

bondholders and full recourse. Historically, European ABS loss rates

are significantly lower than US loss rates. ABS also offer significant

advantages over senior secured loans, with CLOs enabling higher

yields with lower risks than similar senior secured loans.

Now is an opportune time to invest in ABS, given attractive yields,

improving fundamentals, limited supply and potential for capital

gains if spreads tighten.

Figure 10: CLO spreads vs fixed income corporate indices Source: Citivelocity, May 2016

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8th FloorThe Monument Building11 Monument StreetLondonEC3R 8AF

T +44 (0)20 7015 8900F +44 (0)20 7015 8901E sales@twentyfouram.com

This document is intended for Professional clients only and should not be relied upon by anyone else. The information contained in this document is for information purposes only and should not be relied upon as the sole basis for making any decision relating to making an investment. Nothing in this document constitutes a solicitation, or offer, or recommendation, to buy or sell any investment instruments, to effect any transactions, or to conclude any legal act of any kind whatsoever and the information has been prepared without taking into account your investment objectives, financial situation or particular needs.The above data and graphs are provided for illustrative purposes only; the information contained in this document may change, be amended or deleted without notice at any time. Data has been adjusted in its preparation and has been based upon prevailing market rates as at the date given.Past performance is not a reliable indicator of current or future performance. The value of invested monies can increase or decrease and there is no guarantee that all or part of your invested capital can be returned.WHILST TWENTYFOUR ASSET MANAGEMENT LLP BELIEVES THAT THE INFORMATION IS CORRECT AT THE DATE OF ISSUE, NO WARRANTY OR REPRESENTATION IS GIVEN TO THIS EFFECT AND NO RESPONSIBILITY CAN BE ACCEPTED BY TWENTYFOUR ASSET MANAGEMENT LLP OR THE FUND TO ANY INTERMEDIARIES OR END USERS FOR ANY ACTION TAKEN ON THE BASIS OF THE INFORMATION.Although Vontobel Asset Management AG (“Vontobel”) believes that the information provided in this document is based on reliable sources, it cannot assume responsibility for the quality, correctness, timeliness or completeness of the information contained in this document.Except as permitted under applicable copyright laws, none of this information may be reproduced, adapted, uploaded to a third party, linked to, framed. The information in this document is not suitable for use in any jurisdiction where such activity is prohibited. Neither this document nor any copy of it may be distributed in any jurisdiction where its distribution may be restricted by law. Persons who receive this document should make themselves aware of and adhere to any such restrictions. In particular this document must not be distributed or handed over to US persons and must not be distributed in the USA.Potential investors should seek professional guidance before deciding on whether to make an investment.TwentyFour Asset Management LLP is registered in England No. OC335015, and is authorised and regulated in the UK by the Financial Conduct Authority, FRN No. 481888. Registered Office: 11 Monument Street, London, EC3R 8AF. Copyright TwentyFour Asset Management LLP, 2016 (all rights reserved). This document is confidential, and no part of it may be reproduced, distributed or transmitted without the prior written permission of TwentyFour.

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