Asset-Based Finance – too important to ignore

ABF has come to play a more important role in the lending landscape due to the funding gap caused by banks’ tightening lending standards and withdrawal from certain lending activities. ABF is not competing with banks. Instead it is complementary. In many areas, we co-originate deals. We also provide banks with liquidity in secondary markets and, in some areas of ABF, we provide banks with capital relief.

What role can ABF play in a portfolio?

In an environment characterised by interest rate uncertainty, higher-than-average market volatility from geopolitical risks and rising corporate defaults, ABF offer investors important benefits that traditional credit doesn’t.

• Backed by assets: An important share of ABF is backed by physical or financial assets, thereby facilitating the recovery of principal in the event of default. This offers a certain level of protection and resilience in times of economic weakness. A majority is also fully amortising, further reducing downside risk.
• Typically short duration: As ABF differs greatly in duration, it is a way to limit exposure to interest rate risk.
• Income premium: Due to complexity and illiquidity premiums, as well as a more limited investor base, ABF generally offers an income premium compared to traditional fixed income products.
• Greater control: This can range from covenants to, for example, a large investor arranging a bilateral relationship with the borrower which generally results in better alignment of interests and more investor-friendly features. 

Portfolio optimisation through high diversification

ABF can act as an effective diversifier in a traditional fixed income portfolio. In addition to low correlations with publicly traded fixed income, it also has low intra-asset class correlations.

Incorporating ABF into a traditional IG fixed income portfolio

To illustrate the diversification benefits of ABF, we have estimated loss levels and spreads for some of the larger ABF asset classes. We have defined annual stressed losses throughout an entire credit cycle as an appropriate indicator to measure risk. This gives a more accurate picture as volatility in private markets is often difficult to correctly estimate due to the lower trading frequency.

By plotting the risk and return profiles of selected ABF asset classes, we can show how the efficient frontier of a traditional IG credit portfolio - the optimal combination of assets with the highest risk-adjusted return for each level of stressed losses - achieves significantly improved spreads when combined in a diversified portfolio than those achieved on the individual asset classes.

Increased return potential without added risk

In our example, we achieve the optimal risk-adjusted return by replacing 20% of a traditional IG debt portfolio with IG ABF. By adding this optimised blend of ABF asset classes, we achieve better diversification. But more importantly, expected return (‘blended portfolio’, below) rises by over a third with minimal changes to the estimated annual stressed loss of the portfolio.

This example is even more striking when applied to a 'traditional’ high yield debt portfolio. In our analysis, the expected carry of a traditional HY credit portfolio increases by 26% and the annual stressed loss is expected to reduce by 11%.

Optimal ABF allocation in a traditional HY debt portfolio

The investment opportunity

The disintermediation of traditional bank financing continues to benefit ABF. Tighter lending rules and higher interest rates further boost this growth. Technological advances will also have an impact. To give an example, non-bank mortgage lending has risen rapidly in the US due to the rise of online lenders. A similar trend is seen in Europe.

But investors should keep two factors in mind. Unlike publicly traded debt, ABF always requires a bottom-up approach with a detailed knowledge of sectors and issuers. Expertise and access to data, partly gained through a long track record, is essential in this highly diverse market. And size matters. Large investors can source deals that smaller players might not be able to. Size also allows having more established relationships with a larger number of issuers.

ABF offer investors an opportunity to finance the real economy and benefit from diversification and yield enhancement. As more lenders and borrowers discover these attractive opportunities, allocations keep increasing and the asset class is growing both in size and number of sub-asset classes. ABF is likely to follow the same rapid expansion as direct lending has over the past decade, and become too big for investors to ignore.