ABS vs. Private Credit: Why ABS May Offer a Better Alternative
Investors seeking unconventional debt securities should keep in mind liquidity and transparency, which are key features of ABS but aren’t typically associated with private credit.
Key Takeaways
We believe that asset-backed financial instruments may benefit institutional portfolios; however, market securities differ significantly in terms of risk.
ABS provide liquidity and transparency, offering key features that other asset-backed instruments might lack.
Our research suggests ABS backed by unconventional collateral may boost risk-management and performance potential in institutional portfolios.
Although the private credit market, especially asset-backed finance (ABF), is attracting increasing investor interest, its inherent risks may warrant caution.
Instead, we favor ABS, the publicly traded subset of ABF. Our experience suggests these investment-grade instruments represent attractive alternatives for institutional investors seeking heightened income potential from diverse, unconventional debt securities.
In our view, ABS backed by non-traditional collateral may present compelling opportunities for insurance companies and other institutional investors.
Similar to ABF, our research indicates ABS have offered higher yield potential than other fixed-income securities while improving portfolio diversification. However, unlike private credit, ABS feature liquidity and transparency — crucial characteristics that may help manage risk in income-oriented portfolios.
Distinguishing ABS from ABF
Investing in non-traditional securities may help investors lift their income potential while expanding diversification beyond traditional fixed-income securities.
In our view, non-traditional asset-backed securities offer exciting opportunities for sophisticated investors to help enhance performance potential. Investors willing to explore this complex, underfollowed asset class may elevate the income, total return and risk management potential of their portfolios.
The broad asset-backed category includes investments secured by a company’s contractual obligations. Issuers pool similar contracts (such as consumer loans, real estate, aircraft leases and royalty agreements) and securitize them for investor consumption — both public and private.
Publicly traded asset-backed securities include ABS. Banks and specialty finance companies bundle the underlying assets and issue ABS in different tranches that represent varying risk levels. This structure allows investors to buy and sell lower-risk, higher-rated senior tranches or higher-risk, lower-rated subordinate tranches, depending on their portfolio objectives.
In contrast, within the private credit segment, borrowers and lenders directly negotiate loan terms, covenants and maturity schedules. Non-bank financial institutions, including private equity firms and pension funds, typically originate and structure the deals. However, because these securities aren’t publicly traded, they’re often difficult to sell, requiring investors to commit capital for the long term.
Critical Features Give ABS a Potential Edge over Private Credit
Our research indicates that non-traditional ABS have delivered performance comparable to that of private credit with less risk. Most significantly, ABS are generally liquid and transparent, whereas private credit securities are not.
Liquidity
Like other publicly traded assets, investors can buy and sell ABS on the secondary markets. Conversely, investors can't purchase private credit securities in the public securities trading forums.
Because private credit securities are difficult to sell, investors typically hold them until maturity, which could mean locking up capital for many years. Through long investment ramps and multiyear investment timeframes and extensions, private credit investors typically make capital commitments of at least five to eight years.
Transparency
ABS issuers must file standardized information with financial regulators, including the Securities and Exchange Commission. They must disclose detailed information about each underlying asset, including credit quality, collateral and cash flow characteristics, and the deal’s structure. Issuers also must report any material changes in the composition or performance of the security’s asset pool.
On the other hand, public information surrounding loan terms and borrower details in the private credit market is limited. Private credit securities also operate with less regulatory scrutiny than traditional banks and publicly traded assets. This feature could leave borrowers and lenders with limited recourse in the event of a dispute.
Credit Enhancements
ABS typically include internal and/or external credit enhancements designed to help manage risk for investors. Internal enhancements involve structural features that the issuer builds into the ABS:
Tranching. The issuer classifies the ABS into different tranches, each offering a specific level of risk/reward potential. The higher-risk subordinated tiers absorb losses before the senior tranches, thereby lifting the creditworthiness of higher-rated tranches.
Overcollateralization. Focuses on providing a cushion for losses by ensuring the value of the collateral pool exceeds the value of the ABS issued.
Excess spread. Another cover for potential losses, represented by the difference between the interest earned on the underlying assets and the interest paid to ABS investors.
Cash reserves. The issuer sets aside funds to cover any potential payment shortfalls, thus boosting the security’s liquidity for investors.
Among private credit securities, lenders can implement covenants and other screenings to help alleviate downside risk. However, lending to smaller, troubled or less-established companies typically carries a higher degree of default risk compared with larger or higher-credit-quality companies.
Leverage
While leverage can amplify gains in private credit investments, it also can magnify losses, highlighting a key risk consideration for many investors. Leverage accounts for a fairly large portion of the returns that private credit securities expect to deliver.
Without leverage, the projected returns on senior private credit securities remain in line with publicly traded ABS, which typically offer better transparency and liquidity.
ABS May Enhance Yield, Duration and Diversification Profiles
We believe ABS can help institutional investors pursue vital yield enhancement, duration and diversification goals. Institutional investors typically consider ABS for their higher yield potential and more predictable cash flows compared to many conventional bonds.
Additionally, the assets feature lower interest-rate sensitivity than other fixed-income sectors. ABS naturally amortize and pay down each month. Securities in higher tranches pay back principal to investors more quickly, given their priority in the tiered structure.
As a result, all ABS, and especially those in higher tranches, have lower expected durations than most fixed-income assets. Accordingly, we believe ABS can help temper the effects of ongoing interest rate volatility and help investors achieve more balanced duration exposure.
Furthermore, the ABS subsector is diverse, comprising familiar securities backed by consumer and student loans, as well as credit card debt, alongside more esoteric offerings. We generally favor an out-of-ordinary approach, focusing on unconventional, underfollowed and under-allocated debt backed by:
Aircraft leases.
Fiber optics.
Timeshares.
Cellular towers.
Music royalties.
We believe focusing on non-traditional ABS can enhance overall portfolio diversification, performance potential and risk management.
We Believe ABS Deliver Key Features for Institutional Investors
Within the broad asset-backed market, we believe ABS offer important features for fixed-income investors. Given their liquidity, transparency and structural qualities, we generally favor ABS over private credit securities for most portfolios. In our view, these publicly traded securities can help institutional investors manage risk, boost income potential and diversify their portfolios.
We believe high-quality ABS have the potential to provide more attractive and consistent risk-management characteristics than private credit securities. We also believe the shorter-duration profile of ABS further highlights the risk-mitigation and more-consistent performance potential that ABS may deliver to investors.
For private credit and private ABF to remain attractive, investors must see an apparent benefit. Today’s private market has offered little to no yield pickup versus competing public ABS. Accordingly, in our view, private credit investments don’t adequately compensate investors for taking on heightened concentration, liquidity and credit risk.
Authors
Mindset Built for Opportunity
We aim to provide the diversity, steady income and risk management that asset allocators seek from their fixed-income portfolios.
Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.
Investments in fixed income securities are subject to the risks associated with debt securities including credit, price and interest rate risk.
Generally, as interest rates rise, the value of the bonds held in the fund will decline. The opposite is true when interest rates decline.
Diversification does not assure a profit nor does it protect against loss of principal.
The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.