Asset-Backed Securities: Do They Belong In Corporate Accounts?
Executive Summary
Empirical data support the view that AAA-rated asset-backed securities provide comparable investment returns while incurring less credit risk and return volatility than AAA-rated corporate securities.
The annual return advantage of ABS was 5 basis points (bps) over corporate securities in the last six years. The return pickup shot up to 41 bps annualized when the credit market was in distress.
The sector offers about 20 times the number of AAA issuers than the corporate sector, and 10 times as much in market value, making it a better risk diversification candidate.
While historically less than 2% of AAA ABS issues face the risk of a downgrade in a five-year period, 30% of corporate AAA’s lose their top ratings over the same period.
Introduction
Despite the established history and popularity of asset-backed securities (ABS) in fixed income portfolios, there exists a group of corporate treasurers who remain skeptical of the securities’ legitimacy in corporate cash portfolios. This paper analyzes the relative risk and reward characteristics of ABS investments in relation to corporate bonds from the vantage point of a short-duration corporate cash manager. We also offer a highly condensed introduction to the security class and some practical considerations when using ABS in a cash portfolio.
Our empirical analysis reveals that, between 1998 and 2003, ABS, on average, had an annual return advantage of five basis points over AAA corporate bonds, with lower return volatility. We further demonstrate that the primary advantages of investing in ABS are that they are of higher credit quality, with more investment selections, diversity, and diversification.
For our analysis, we drew empirical data from the Merrill Lynch Asset-Backed Securities Master Index and the Merrill Lynch AAA-Rated 1-3 Year US Corporate Index to represent the respective asset classes. Both indices have a credit rating of AAA and approximately the same level of interest rate risk, which make performance comparisons meaningful.
Though some corporate cash portfolios are shorter than the represented ABS Master Index, currently at 1.8 years, one may reasonably deduce that the return characteristics are proportional to their investment horizons. We do believe, however, that the higher complexity of ABS structures demands a higher level of investment expertise and analytical capability than is the case with corporate bonds.
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