investors without means urged to avoid asset backed securities because of their complexity
Investors without the resources to perform diligent scrutiny of asset-backed securities (ABS) should beware buying these complex instruments, fund managers warn.
ABS are bonds issued by specially set up special purpose vehicles (SPV). In contrast to conventional capital market securities such as corporate bonds, these SPVs are backed by a pool of discrete assets, rather than just the general obligation of a bank or company.
ABS pools can hold a variety of assets that generate a set of future cashflows. In recent years, the range of assets has expanded to include pubs, hospitals, gate receipts at sporting venues and even future royalties generated by musicians. Investors are mainly financial institutions.
The core attractions of the ABS market is as a source of relatively higher yielding securities for investors and of cheaper alternative funding for firms.
John Cummins, head of treasury at Standard Life Investments, noted the counterpart to these potential rewards is their more opaque nature. This means investors must undertake considerable stress testing before considering them as a potential investment and they must be vigilant in scrutinising these securities after the initial purchase.
Jim Leaviss, head of retail fixed interest at M&G Investments, said: "Our ABS team can still find interesting opportunities but have been warning that recently there has been indiscriminate buying of ABS by investors without the resources to have carried out in-depth credit work. This has driven up the prices of some of these bonds beyond levels where we can see adequate compensation for the default risk and illiquidity."
Standard Life Investments believes the ABS market faces regulatory changes in various jurisdictions that will alter the way business is conducted.
Cummins said the Basle II Accord in Europe aims to level the playing field for issuing securitised products. This could possibly improve the outlook for riskier ABS supported by both small commercial and unsecured consumer loans relative to traditional securitised asset classes, notably residential mortgages. He added: "Harmonisation will not be immediate and it is too early to gauge whether Basle II will be an overall positive for the ABS market."
In the UK, regulation is also playing its part in encouraging the use of the ABS market as a tool for capital raising. Typically, other participants such as hedge funds are also likely to take advantage of the growth in this market, said Cummins.
Other changes affecting the ABS market include the provisions of IAS 39, a new international accounting standard to be implemented in 2005, which will govern the removal of financial assets or liabilities from the balance sheet.
In the US, corporate scandals derived from abuses of asset securitisation, notably Enron, have persuaded the SEC to consider formal regulation of the ABS market.
Cummins said the ABS market has exploded in recent years, with US issuance rising more than fivefold in 10 years, reaching $530bn in 2003. US issuance of collateralised mortgage obligations, which is counted separately, increased from $235bn in 1997 to $976bn in 2003. Standard Life Investments said in Europe ABS issuance has risen 30% in the last year.