Demystifying Asset-Backed Finance

Greg Campion: Asset- backed finance has garnered much attention in the last several years. Driven by trends like bank retrenchment and investor demand for income and diversification, the asset class has experienced rapid growth and it's been hailed as a core part of what's being branded as private credit 2. O. Despite this newfound popularity, a number of questions remain, from how to properly define the asset class, to how it may perform through a cycle.

Yulia Alekseeva: There's still a lot of confusion on what asset- backed finance means, what does that universe entail, and what are the various diverse asset classes that are included under the hood of asset- backed finance.

Greg Campion: That was Yulia Alekseeva, Head of Consumer ABS at Barings, and this is Streaming Income, a podcast from Barings. I'm your host, Greg Campion. Coming up on the show, demystifying asset- backed finance. Before we get into it, just a quick reminder that you can follow Streaming Income on Apple Podcasts, Spotify, and if you want the full video episodes on YouTube as well. With that, here's my conversation with Yulia Alekseeva. Yulia Alekseeva, welcome to Streaming Income.

Yulia Alekseeva: Nice to see you, Greg.

Greg Campion: Excited to have you here. I feel like this has been a long time coming. I've been wanting to have you on the show for a long time, so this is great that we are finally getting to do it. And since it's your first time on the show, I thought maybe we could just start with a quick intro. I think our listeners would love to hear just a little bit about your role here at Barings and maybe what you were doing beforehand.

Yulia Alekseeva: My name is Yulia Alekseeva. I head our consumer ABS business here at Barings. I started my career in accounting and audit, qualified as a chartered accountant that was in Russia in Cyprus with PricewaterhouseCoopers. And I really liked the precision of it, but what I quickly realized that it's very backward- looking in nature, and I wanted to do something more forward- looking where I can be the decision- maker, where I can really get closer to investing, to getting deals done, rather than ensuring that it's all accounted for correctly. And so that brought me into the US, a couple years doing my MBA at Wharton, which ultimately led to me entering the ABS banking world. And that's really where I spent time understanding how transactions work, how the collateral is valued, how it performs, how the deals are syndicated. And after a couple of years doing that, I was ready to put on my investor hat and move on. And ultimately when I switched to Barings Babson at the time, I was investing in a lot of the same deals that I previously helped create packaged and distributed. So it was great being on the other side because you can see both sides of the coin. And I would say ABF initially attracted me as a space that is probably one of the most complex and innovative corners of the financial markets, and it's certainly something that I've been appreciating over the years of doing this. It's very non- formulaic, it's not plain vanilla. You have to understand people, processes, structures, waterfall scenario analysis. There's definitely no shortage of intellectual stimulation. And so it does require you to roll up your sleeves to get into the weeds. It does require you to bring your whole brain to the table, your left side and your right side, your analytical and your creative intuitive, and really combine them in order to be able to figure out how everything works.

Greg Campion: I love the way that you positioned that, just in terms of when you're thinking about asset backed finance using both sides of your brain. And I think that's really interesting way to think about it because this market does require creativity and structuring with a lot of the transactions that happen. And there's a certain degree of complexity. And I guess that's the reason why we're doing this episode today and why we want to demystify, so to speak, asset backed finance. So maybe let's start there. I'd like to start high level and just talk about asset backed finance. I'd be interested in just if you can help us define our terms a little bit. So help us think about what is asset- backed finance, how you think about that overall universe today. Maybe we can start there.

Yulia Alekseeva: Yeah, absolutely. And I think that's the right place to start because there's a lot of jargon being used. Asset backed finance, asset backed securities, securitized credit, structured finance, specialty finance. They all technically refer to the same concept and the same thing. And so in simple terms, I think of asset backed finance as a form of lending, secured by a pool of assets with contractual cash flows. And so those assets can be mortgages, can be auto loans, student loans, credit card receivables, but it's really the process of how you make real world cash flows, including things like planes and trains and even cell phone bills, and convert them into investable instruments. Which basically makes the cost of funding cheaper across the ecosystem. That's the biggest benefit. And all that to say that asset- backed finance is touching so many parts of what you're looking at, the buildings, the planes, the containers that cross the oceans to get goods to us on a daily basis. And so asset backed finance has been playing a very critical part of the global market and the credit ecosystem. And just to break it down even further, I simplistically think that ABS with the securities component in the end is the public portion of it. It's the broadly syndicated, it's the liquid market. It does have the liquidity because it has broader market reach. It's typically underwritten and distributed by broker dealers, it comes in public or 144A format. But that is typically coming up for investors and conversation about fixed income allocations because it does provide yield enhancement versus treasuries or corporates. On the flip side of that, ABF is typically the private portion of the asset- backed credit market. And so what that means, this are non- public transactions, they are privately negotiated, typically bilaterally. Sometimes there's a small club of investors that participates. And so you have more ability to influence structures, you have more ability to influence terms and pricing, which you don't necessarily have on the public side where you're more of a risk- taker, rather than risk maker. And so that comes typically in 4A2 format. A lot of it is buy to hold type of investments because there is no inherent secondary liquidity afterwards. And so private ABF typically comes up in conversation around private credit, around real assets, around alternatives because it provides the yield enhancement component to more traditional parts of private credit markets.

Greg Campion: I love that context. So you've got the public side, the more securitized ABS side, the private asset- backed. As you look at all of the different things that are being securitized and that come under this broad umbrella of asset- backed finance, can you just name a few of those? And I think it's a little bit of a moving target. Some managers put this asset class under ABF, some don't. But maybe just thinking that broad brush, what's under that umbrella, high level?

Yulia Alekseeva: Yeah, you were spot on, Greg. I think there's different ways to divide the world or think about it. So we at Barings use for verticals to just standardize and put it in explainable pockets, that we can underwrite based on underlying risk. So the first one is consumer ABS, and so that is really any asset that's backed by consumer credit where you are effectively underwriting to a borrower's FICO. So I'm going to name a couple of things. It's not an exhaustive list, but credit card receivables, student loans, auto loans, healthcare or medical loans, timeshare, solar loans, home improvement loans, unsecured personal loans, residential pays. And I can go on, but I think you get the gist of it.

Greg Campion: Consumer exposure broadly and maybe we'll get to it, but that would be interesting to hear what you're seeing around some of those trends at this moment, given what's going on in the economy, but continue, we'll come back to that.

Yulia Alekseeva: Yes, it's very timely and relevant and we can unpack that.

Greg Campion: Yeah.

Yulia Alekseeva: The second vertical is commercial ABS. So those are pools that are backed by assets with business loan or underlying business lease component. So once again, that has evolved in breadth over time, but it includes things such as all facets of transportation, aircraft receivables, planes and underlying leases, containers, trains, franchise receivables, any sort of royalty streams, digital infrastructure, pharma, securitizations, more recently, music royalties. So the list once again is continuing to expand, but you're not looking through to an individual person with a FICO on the repayment of your debt. That's the biggest distinction between consumer and commercial on the ABF side. Then the third one is residential. And so that's really residential mortgages, I think prime, subprime, non- QM, post GFC, home equity lines of credit, et cetera. So the underlying is obviously linked to a house, which makes it very distinct. It's a huge part of the economy and that has evolved tremendously since we've learned a lot of lessons plus the GFC. And then last but not least, the fourth vertical, the way we think about it is the commercial mortgage- backed vertical. So it is more closely aligned to real estate, but it effectively includes three flavors. Conduit transactions, which is a hodgepodge or mix of multiple underlying loans, single assets, single borrower transactions, which is more distinct, isolated type of place. And then CREC laws, which is more transitional properties and shorter in nature. But all of those are supported by various property types. So office, retail, industrial, multifamily, logistics, data centers as of more recently. So this is how we define it, and I think you do want to have centers of excellence because the way you underwrite a pool of 20 aircraft, is going to be massively different from the way you underwrite thousands of auto loans, just in terms of using, understanding different regulation, using different assumptions and performance drivers using more quantitative versus some more qualitative overlays in your work.

Greg Campion: I mean, the thing that jumps out to me is just how broad the universe is. You mentioned up upfront ABF touches everything around you, whether it's these buildings or aircraft or so many different things. But when you hear that description and the four verticals that you described it in, by the way, I'm immediately thinking, " Okay, needs to be a white paper." And so-

Yulia Alekseeva: That's right.

Greg Campion: ... we need toput this out so people can visualize it, but it seems like it's a really broad based... You get a real broad based view of the economy, both consumer and commercial, across this space. So that jumps out to me and then fully take your point that it's a different animal trying to underwrite a music royalty versus a credit card receivable or something like that. Let's come back to a couple of those points, but maybe before we do that, can we just talk a little bit about the momentum that this space has had recently? So thinking back, we've all seen probably over the last 10 to 15 years the massive growth in the middle market direct lending space. And it seems like one of the popular things to do out there these days is to call what's the next direct lending, right? What's private credit 2.0 is being used as a term to brand a lot of different asset classes? I'd be interested in just hearing your views on what is it that is driving, I guess, so much traction in this increased notoriety of asset- backed finance in recent years?

Yulia Alekseeva: Yeah, you're spot on. I think every private credit conference this days has definitely a panel on asset- backed, and it's typically called the Next Frontier of Private Credit.

Greg Campion: Next Frontier. Yeah.

Yulia Alekseeva: Yes. Not surprisingly so. So a couple things, the way I think about it, and maybe going a little bit to the era post- GFC, what happened with the bunch of new regulation that was put in place to provide guardrails around the asset class, it also created a lot of constraints for banks in lending based, to securitize credit. And so we've seen continued bank retrenchment and so that created a void that created a liquidity gap for non- bank entities to step in and provide capital, provide financing where otherwise you wouldn't have an alternative traditional option. So that has continued over the last 10, 15 years. And I think now the banks are much more focused on their balance sheet efficiency. So I think the banks are much more deliberate and intentional with how they think about deposit volatility lately, which also leads to the fact that for some assets, alternative lenders are better positioned to provide that. On the demand side, the most important piece of the puzzle that's new and has emerged over the last few years is the interest from the insurance channel. And so if you think about insurance companies, typically life insurance long- dated investment, you want to match it from an asset liability matching perspective with long- dated investments. But since effectively 2022, we've seen a massive surge in annuity sales and they are a shorter product. And so that's why insurance companies have been very focused on finding higher yielding opportunities to match those shorter tenors. And guess where you find a lot of that? ABS and specifically consumer asset backed credit, which tends to be shorter in nature, it's faster, it amortizes over time as people pay down their financial obligations. And you can still pick up complexity premium associated with it. It does provide lower correlation to other parts of portfolios insurance companies already have in place, which tend to be investment grade quality in nature. They are high quality portfolio and you have structures that provide you with that higher quality tilt, more downside protection. So it's not been surprising to see insurance capital really step in to the private ABF world with more appetite in recent years. And then the last thing I'll say is even pension funds. Now that a lot of them have reached overfunded status, they're now in a position where they can de- risk out of equities that have become rich or out of credit into pockets of less liquid markets, where they can get the additional illiquidity premium that will compound over time. So I think bank retrenchment, insurance stepping in and then all the other participants in the market getting interested in this more complex nuanced space that have been a little bit underappreciated over time.

Greg Campion: You mentioned earlier in your description of the asset class, the public market side of things and the private market side of things. Can we just talk a little bit more about that? Because I know there's a lot going on there. We see including some of the content that Barings has put out, this theme of the blurring of lines, so to speak, between public and private credit. Maybe talk a little bit about that and I'd be curious if you're seeing that blurring today. And then are there any examples? I think you and I have talked before about issuers that maybe go between public and private markets and tell me a little bit about that because Barings obviously is very active on both sides of that. So I'd just like to hear your high level thoughts on that blurring of lines trend.

Yulia Alekseeva: Yes. Blurring of the lines is I think is one of my most commonly frequently used phrases this year. So the convergence between public and private credit is ongoing. The way it pertains to asset- backed or asset- based finance world is that typically you have a pool of assets underlying collateral and you can package it or structure it any way you want. You can finance it in a bilateral fashion or you can go to broadly syndicated market. But underlying is the same. What we've seen is that over time the originators of assets tend to value to different things. Some values are to of execution and they don't want to take the risk of going to the public markets, particularly maybe at a more challenging time where you might not get a deal price, right? They're reliant on the certainty of that cash flow to support their business for going concerned reasons. They might lean more into private space. Some originators might just be too early stage to be able to tap capital markets. So they need to gestate in more private format, build more track record, build more history, build more standardization, and then they'll evolve and graduate into capital markets. So there's a lot of scenarios where I think the important piece is if you understand the whole ecosystem, if you understand the valuation of the assets, the packaging becomes a secondary item. And you can figure out which format is the more optimal based on the market conditions, based on the borrower needs, based on our client needs as well. And so you can structure something that works in the best way possible given fluidity in the market. And back to the illiquidity premium that we've talked about, all things being equal, if you're getting the same pricing in public and private markets, that means you're not getting compensated for illiquidity on the private side. So I think managers that have ability to play both parts of the equation that have two levers to pull and can nimbly move, based on the relative value shift, across public and private formats will always capitalize on that momentum. So that I think is becoming a competitive advantage versus people who only have one lever who just do private or just do public. And I think that convergence becomes much more pronounced. In many cases, we are witnessing processes where the conversations are happening on both sides, and ultimately in the last minute they'll decide which format makes sense. And so sometimes it's plan B, sometimes plan B becomes plan A, right? We're going through very turbulent markets right now. I think we're going to see some of those situations pop up where decisions will need to be made and sometimes public markets will not be the most optimal, best price and certain way forward.

Greg Campion: Interesting. And I know that recently in the last year or so there was some changes in terms of how your team was set up and structured, probably due to the way the market's evolving. You want to comment on that a little bit?

Yulia Alekseeva: Exactly. Yeah. So we are following this convergence of public- private, and what we've done is we've combined our public and our private securitized groups into a single$ 70 billion private placements and asset- based finance platform, which now spans all of the sectors and all of the formats that we've talked about. I think it's really in the spirit of times that we are doing that because we do want to be able to harness that relative value shift across markets for our clients. We do want to be able to capitalize on the growth in private asset- based finance. If you look at the estimates of based on McKinsey private credit report, they're expecting private ABF to grow to north of 20 trillion across securitized credit and consumer finance in the future, which is larger than the public investment grade and high- yield markets. So the scale of the opportunity ahead of us is massive. And so that's why I think that continued momentum to grow the private side in addition, or I guess in parallel with the public side will continue. I don't think we're nowhere near the point where one market will cannibalize the other. It's just right now the size of the pie continues to increase. And so part of what we've done is, we've converged, we've merged the groups, and so we're better able to serve our clients. And I think what's important to stress is that gives us the ultimate ability to customize for client needs. And so what I mean by that, clients can decide where in the rating spectrum they want to play all the way from AAA, to high- yield, to residuals. ABF now provides them the whole blend across the structure.

Greg Campion: Sometimes these huge numbers like the 20 trillion, it's hard to get your head around, but when you think about all of the different segments of the market that you mentioned, and that are part of this universe. And then you think about just the broad growth that we're seeing in private assets overall, and I would think you could define that probably as a mega- trend, that investors just broadly have gotten much more comfortable with private assets over time. It seems like that's still only going in one direction. It makes sense that this will continue to grow. And then I think when you talk about some of the benefits in terms of it being customizable, both from an investor point of view, but also from an issuer point of view, it does make a ton of sense. And to me it's really interesting to think about that issuer perspective as well, especially as you move into these more potentially turbulent times that we're seeing right now. And you need to be a lot smarter around when you're issuing, where you're issuing, the terms you're getting. And so to have all of that together, and not to make this too much of a Barings commercial, but to have all of that together and to be able to partner with managers who can look through, see the whole picture there, seems super important right now.

Yulia Alekseeva: Exactly. And I think the time is very important. The reason why ABF is also garnering additional attention is, people compare and contrast it to corporate credit. And so if you think about the underlying risk in corporate credit, you lend to a single entity. And so you're relying on the business plan, on the execution of that business plan. Whereas an asset- backed, you are lending against a diversified, granular, transparent pool of assets, think thousands of auto loans that you were created last year. So you don't have a single point of failure. That diversification becomes important, it offsets a lot of risk. And then as we are potentially getting to an environment where we might see more defaults and more bankruptcies, the legal structure of asset- based finance, which relies on creating bankruptcy- remote vehicles, that ring- fence the assets and separate them from the sponsor from the issuing entity is going to become increasingly more important. It's going to help in workout situations. I think that's a critical component of how securitization plumbing works. That sometimes also goes a little bit underappreciated, but I've personally seen it time and time again. In 2020, we've lived through a number of bankruptcies in the market. And so while the corporate sponsor went down, we've seen the assets that were in those securitization trusts continue to perform, continue to maintain their investment grade ratings, AAA ratings. And so I think that bifurcation has become very visible, and once again is part of the concept why securitization is such a brilliant idea. And so legging into that right now makes more sense. And then the last thing I'll say is, with inflation concerns being top of mind. I do think asset- backed finance provides a great inflation hedge. So once again, if you compare it to corporate credit, if inflation spikes, typically profit margins gets squeezed unless you can pass a hundred percent of that through to the consumer, which in many cases is just not feasible, consumer can only take so much, right? And they've already taken-

Greg Campion: We're seeing like we're going to be testing how much the consumer can take, yeah.

Yulia Alekseeva: But in the asset- based world, the values of assets sometimes hold their value or sometimes increase in value. And once again, a classic example was in post- COVID world supply chain disruptions really affected prices of auto vehicles, and we've seen 20, 25% appreciation for used vehicle prices in a single year because of scarcity impact. So those assets were backing the asset- backed deal. So once again, very different dynamics where you have that inflation hedge just by the virtue of appreciating assets underneath the structure.

Greg Campion: Okay. Well, I'd like to get your view on opportunities and risks and especially I think the risks, some of which you've alluded to already are worth diving into a little bit because just everything we're seeing in markets recently. So let's start with are there areas that you're excited about as you look forward, let's say the next 12 to 24 months?

Yulia Alekseeva: Yeah, so I guess I'll preface it by saying that if you think about ABF from an asset class perspective, I think the biggest shift that will happen is that it will become a strategic allocation for a lot of investors. Not necessarily an opportunistic allocation, but-

Greg Campion: Do you think it is in that respect becoming the next direct lending in some ways?

Yulia Alekseeva: It's transitioning to become a core building block of private credit portfolios. I think that's underway and that will probably accelerate in the near term. So that's one thing. Second, if you look at macro, a lot of what we've talked about, structural protections will become more important. We haven't really dug into some technicalities, but there's a lot of things that will protect investors on the asset- based side. You have over- collateralization, you have credit enhancement, you have excess spread, you have performance triggers, reserve accounts, cash apps mean I can name a lot of things.

Greg Campion: This will all be in the white paper folks eventually when we produce it. Yes.

Yulia Alekseeva: The whole idea is those are things that insulate or shield you from losses. So sometimes I get asked this question like, consumers under a lot of stress, does it mean everything's going to underperform? And the answer is delinquencies and defaults do not necessarily translate to losses if you've structured it appropriately. So the key will be conservatively underwriting to be able to weather a recessionary scenario and still be money good. And that's possible, and that's been done before. And I think that's what really sophisticated investors are focused on right now. Specific sectors. I think consumer, despite the fact that there is a lot of pressures coming up in compounding over time from tariffs, is still two- thirds of the US economy. It's still a massive opportunity. And I think if prices of everything go higher, there's still going to be a meaningful financing need. But the key is to be a smart investor and not underwrite to optimistic assumptions, not to have recency bias where you are forming your view just based on the last few years of very positive performance, which was unusual and artificial because of ultra- low rates, because of fiscal stimulus, et cetera. Those vintages, I would say were outliers. You need to have a through- the- cycle view going forward. I think in commercial ABS is a lot of interesting new and evolving asset classes that will continue growing in significance. A lot of digital infrastructure for example, I think that'll be another theme which is fueled by AI tailwinds. But you have to be cautious. Small business loans will potentially have the same issues as the consumer segment. And then we are constructive on housing. It has been a very strong point, great relative value when we look at it across all of the sectors. And once again, I think that's something with the right structure that will perform very well and has evolved over time, know post- GFC to be a very different, very resilient kind of product into the future. So a lot of places to play in. I think the key point I would make is that investors still remain under allocated to asset backed credit, and as other parts of the market are becoming more correlated, this is still one unique pocket where you find less correlated income streams, return drivers and just ability to find opportunities that will not perform the same exact way as the rest of the market. Which I think is becoming very top of mind.

Greg Campion: Yes, yes. We've seen some... Things tend to move toward correlation of one when markets are very turbulent-

Yulia Alekseeva: Exactly.

Greg Campion: ... aren'tthey? You've alluded to some of the risks along the way, but anything else you would want to highlight in terms of keep you up at night sort of things? Or at least things that we want to think about mitigating other risks that we want to think about mitigating through underwriting or through other means?

Yulia Alekseeva: Yeah, so I mean I'm bullish on ABF, but I'm not blind to the risks. I'm glad you're asking that question. Right now, what's top of mind for me is just the origination quality and platform risk. And so what I mean by that is, what we've seen in GFC and the lessons learned is if underwriting standards loosen beyond reasonable, that's where you're going to start running into problems. Even great structures will not save bad underwriting underneath. So I think that's what we're watching, making sure that the standards remain robust, that everything's underwritten to ability to repay appropriately. And there are a number of players that have emerged in the last 10 years but that have not been tested through a cycle environment. And so that to me is always a little bit of a question mark. They're great, innovative business models, a lot of buy now, pay later falls into that. And I think they have performed well in the last decade, but I don't know how they're going to perform in a very unique GFC type of scenario.

Greg Campion: Sure, sure.

Yulia Alekseeva: So that's top of mind. And then liquidity. I think investors focus on credit risk a lot, but we are seeing rapid shifts in sentiment in market where liquidity can just create those weird aberrations that will impact the asset classes and will inevitably impact the asset- based world as well. And so that's something that I worry about in an environment that we are finding ourselves in right now.

Greg Campion: Well, we are coming to the end of our conversation. I feel like I've learned a lot. Hopefully our listeners have, I feel like this is chapter one in this conversation to some degree because I think there is just so much there and so much for us to follow up on. And I think hopefully we'll be doing more podcasts like this, doing more content to help investors really understand this space, especially as it continues to evolve. Are there any additional resources that you would recommend to people? Anything out there in terms of reading, listening that they want to?

Yulia Alekseeva: Well, the first thing that comes to mind is probably the Big Short by Michael Lewis. I think it's a great book. It's a great movie. And not to take it lightly, but it does follow a few people that were seeing the writing on the wall with respect to the subprime housing crisis. And I think the lessons learned from that is that structures sometimes are too opaque and you really need to have the expertise, the understanding of the data and being able to dissect it and look through the noise, versus the actual data points and have conviction to invest. And so I think that's why I securitized this, it's a great concept if used appropriately.

Greg Campion: I see. Yeah.

Yulia Alekseeva: And so you need to partner with an experienced manager who has been through multiple cycles. I think it's easy to invest in a bull- only market, but really where you grow your expertise is by going through some challenging situations, by doing the workouts, by going through a wave of defaults, by navigating servicing transfers, restructurings. And so this is where you really cut your teeth. And that's what makes you smarter as an investor where what can go wrong, not just what's the upside, but what can really get us and how quickly it can get us. Because I think once the leverage works its way through the system, we've seen in 2008, it can unfold very quickly. So that risk monitoring has to be part of DNA, and so part of investing in that asset class as well, this is why we rely on monthly remittance reports. We see what's happening, what's happening with the delinquencies, what are the trends, what are the lowers? What are the recovers? Keeping your hand on the pulse of that is very important in a very rich data heavy sector, such as asset- backed finance.

Greg Campion: I feel like you answered that question in a very credit manager type of way with their risk mitigation top of mind. So as an investor, I think that's hopefully comforting to hear. This has been great. I feel like I've learned a lot. Hopefully our listeners have as well. And yeah, I look forward to hopefully doing more of this in the future. But Yulia, this has been awesome. Thank you.

Yulia Alekseeva: Yeah, it's been great find asset-backed fans with you.

Greg Campion: Awesome. Thanks for listening to or watching this episode of Streaming Income. If you'd like to stay up to date on our latest thoughts on asset classes, ranging from high yield and private credit to real estate debt and equity, make sure to follow us and leave a review on your favorite podcast platform. We're on Apple Podcasts, Spotify, YouTube, and more. And if you have specific feedback, you can email us, at podcast @ Barings. com. That's podcast at B- A- R- I- N- G- S. com. Thanks again for listening and see you next time.