Talking Heads – Les prêts aux ménages, une classe d’actifs alternative pour 2024

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.