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PORTFOLIO PERSPECTIVES | PODCAST – 12:48 MIN

Talking Heads – Household loans, an alternative asset class for 2024

Daniel Morris
By TONKO GAST, DANIEL MORRIS 10.01.2024

In this article:

    The start of 2024 sees an economic environment where growth in developed economies is slowing as restrictive monetary policy makes itself felt. Investors looking to alternative markets for portfolio diversification and the potential for attractive returns could well consider a new, relatively unknown, but high-quality asset class: household loans.  

    Loans to higher income households in the US, Europe and potentially in Asia have tended to exhibit low mark-to-market volatility and low default rates. These loans come with a comparatively high coupon that helps absorb losses. Other characteristics of the loans, typically made to creditworthy earners to consolidate debt into a single, cheaper loan, include a 3-5 year maturity and full amortisation.

    Tonko Gast, founder and CEO of Dynamic Credit Group and Portfolio Manager, discusses the asset class with Co-Head of the Investment Insights Centre Daniel Morris in this Talking Heads podcast.

    You can also listen and subscribe to Talking Heads on YouTube and read the transcript.

    Talking Heads brings you insights on topics that matter to investors, analysis of the world and financial markets, and conversations with our investment experts, all through the lens of sustainability. 

    XXX BNP AM

    Read the transcript

    This is an audio transcript of the Talking Heads podcast episode: Household loans, an alternative asset class for 2024 

    Daniel Morris: Hello and welcome to the BNP Paribas Asset Management Talking Heads podcast. Every week, Talking Heads will bring you in-depth insights and analysis on the topics that really matter to investors. In this episode, we’ll be discussing diversified loans. I’m Daniel Morris, Chief Market Strategist, and I’m joined today by Tonko Gast, CEO of Dynamic Credit Group.  

    In the US, the consensus view today is an expectation of a soft landing – slower growth, but not a recession – and core inflation moving back towards the US Federal Reserve’s 2% target. 2024 should be a year of positive growth, albeit slower than in 2023, and lower interest rates.  

    How quickly that happens and how far rates fall is important when we consider the outlook for diversified loans. For our listeners who are not so familiar with the asset class, could you tell us what diversified loans are? What are some of the key features and why do you believe it is an interesting area to invest in? 

    Tonko Gast: Diversified loans is a broad asset class of loans to households in the US and Europe. It covers all kinds of loans, from prime to subprime and very high-risk. We focus on prime or near-prime household loans, which are typically for debt consolidation.  

    That means these are households that have debt from an earlier stage in life and they want to consolidate their existing debt (which is usually at a high cost) into a longer-term, cheaper loan. This can have a positive social impact because it allows households to spend less on debt and it usually reduces their debt over time.  

    This is an important point of the asset class. All these loans are fixed rate and amortising. Typically, they amortise over the three to 5-year maturity of the loan and the borrowers pay a fixed monthly instalment. As they amortise every month from the start down to zero after three or five years, the average life is typically much shorter than the three to 5-year maturity on the loan.  

    This amortisation creates a very short duration of typically between one and two years. For example, a loan of, 10 000 euros or dollars that pays down from the start typically pays about 5 000 euros or dollars in cash flow in just the first year. That should give you a good sense of cash flow, which includes interest, principal and prepayments. It’s an important feature that I’ll come back to later.  

    What this does for investors – making it attractive as an asset class – is create semi-liquidity, adding underlying monthly instalments that borrowers pay of some 50% per year. That creates an interesting liquidity profile for people investing in diversified loans, and one that is quite different from the typical private debt investment or almost any other credit or fixed income investments that don’t have that kind of cash flow element.  

    One further feature to mention is that from a return perspective, we’re seeing in this asset class in the current environment around a roughly 650-basis point spread. That’s a spread over two-year swaps in dollars or euros. With loss expectations in the asset class currently around 250 basis points, that leaves a solid 400 basis point or 4% spread over euro or dollar swaps after loss of expectations.  

    DM: The consensus expectation for 2024 is that interest rates will fall – it’s just a question of how quickly and how far. In that environment, how would you expect diversified loan investments to perform? 

    TG: The coupons on these loans remain constant as borrowers pay fixed instalments. The coupons are locked in for three to five years and we reinvest on a daily basis all the cash flow that comes back. The platforms that we buy the loans from typically lag the [key interest] rate by two to three months. That means we will reinvest at some point at lower rates, but there’s a lag which can be attractive for investors because we keep rates in the strategy higher for longer than, for example, money market funds, where coupons and returns follow the market rates far more closely.  

    That’s one positive when rates are declining. We can also expect a positive mark-to-market effect as rates fall.  

    This strategy had some headwinds from rising rates in the past, as did most credit and fixed income strategies over the last two years, which kept rates more muted. But we need to keep in mind that this is a shorter duration strategy, so it should not be volatile, but the coming rate environment should give it a tailwind. With the gross 650 basis point spread over swaps, you might have more upside from the market tailwind than expected.  

    DM: Given the outlook of interest rates falling, we would anticipate money coming out of money market funds and going into other asset classes. Do you see 2024 as offering a good entry point for diversified loans? 

    TG: It could be a perfect entry point. Because of the rate increases, there’s some discount available that investors can buy into. As said, the fixed rates are locked in for longer, so when market rates decline, a positive mark-to-market is expected, while the coupon returns are likely to stay slightly higher for longer.  

    New loans benefit from tighter underwriting, lower future expected losses, and the potential for generating fairly stable and predictable spreads. Is that interesting for people looking to come out of money market investments with very short duration? You stay in the semi-liquid, low volatility space. So it could be interesting when you’re perhaps over-positioned in money market exposures to come out of that, making this a possibly good entry point [into diversified loans] early this year.  

    DM: When we look at the performance of the asset class, the returns for the diversified loan segment have been not particularly volatile, certainly compared to longer duration fixed income. What’s the key driver of that low volatility? 

    TG: Annual volatility of less than 1% is quite striking. The performance chart of this asset class shows as straight a line as money market funds, with the difference of over 650 basis points.  

    What drives the low volatility is the amortisation of the underlying loans, which creates low loss volatility because you lower the credit risk as the outstanding balance is reduced from the first month. Every month you get 50% cash flow. That in and of itself lowers the credit risk and volatility. The borrowers have fixed coupons which can benefit investors as it keeps the credit risk fairly predictable and not overly dependent on the rate environment. 

    DM: Thanks, Tonko, for educating us on the diversified loan asset class and highlighting some of the key characteristics, such as relatively low volatility.  

    Disclaimer

    Please note that articles may contain technical language. For this reason, they may not be suitable for readers without professional investment experience. Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice. The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns. Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions). Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.
    Environmental, social and governance (ESG) investment risk: The lack of common or harmonised definitions and labels integrating ESG and sustainability criteria at EU level may result in different approaches by managers when setting ESG objectives. This also means that it may be difficult to compare strategies integrating ESG and sustainability criteria to the extent that the selection and weightings applied to select investments may be based on metrics that may share the same name but have different underlying meanings. In evaluating a security based on the ESG and sustainability criteria, the Investment Manager may also use data sources provided by external ESG research providers. Given the evolving nature of ESG, these data sources may for the time being be incomplete, inaccurate or unavailable. Applying responsible business conduct standards in the investment process may lead to the exclusion of securities of certain issuers. Consequently, (the Sub-Fund's) performance may at times be better or worse than the performance of relatable funds that do not apply such standards.
    Private assets are investment opportunities that are unavailable through public markets such as stock exchanges. They enable investors to directly profit from long-term investment themes and can provide access to specialist sectors or industries, such as infrastructure, real estate, private equity and other alternatives that are difficult to access through traditional means. Private assets do, however, require careful consideration, as they tend to have high minimum investment levels and may be complex and illiquid.

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