Stomaching Subprime: Seeking Value in Auto ABS

Subprime. It’s the eight-letter word that turned into something of a four-letter word during the 2008 global financial crisis. Even now, ten years later, that stink has not washed off. Investors have been eyeing subprime auto asset-backed securities (ABS) for signs of trouble, wondering if growing auto debt levels, rising interest rates, deteriorating performance and changing issuer composition could mean the next subprime storm is brewing.

So is it? I don’t think so. Yes, delinquencies and losses in subprime auto have risen, and that’s nothing to dismiss. But I think it’s more important to look at the fundamentals of the borrowers, issuers, and deal structures in the subprime auto ABS market. In my opinion, investors who focus on fundamentals and are undeterred by the sector’s infamous moniker may find compelling value propositions.

Fundamentals in focus

Here’s my assessment of the subprime auto ABS sector:

  1. Borrowers: Subprime performance is highly correlated with employment. Auto debt is most often related to the borrower’s need to get to work, and those with a job generally pay their auto loans. Unemployment is extremely low today, and now that the economic recovery has matured, lower-income earners are finally starting to feel wage gains (which tend to accrue to prime borrowers earlier in recoveries). Are rising rates an added stressor? The reality is subprime borrowers are always under financial pressure. This group actually feels less pressure from rising rates than their prime counterparts because they are already paying high interest rates—sometimes the maximum rate allowed by law.