Record low interest rates have helped investors rediscover a taste for bonds backed by everything from pizza to movie royalties, even though strong demand for these offbeat assets has already trimmed returns.
Over the last year, investors have snapped up debt backed by royalty fees from franchise restaurants such as Domino’s Pizza to timeshare loans on vacation properties around the world, and analysts expect demand to grow in 2013.
With the Federal Reserve not expected to lift interest rates from near-zero anytime soon, banks and some fund managers are increasingly advising clients to consider these non-traditional asset-backed securities, which offer higher yields than other types of investment-grade debt.
Demand has been so strong that the value of many bonds, which are typically held to maturity, have soared in secondary market trading, allowing investors to sell them at a profit.
The yield on $350 million of bonds backed by Miramax’s library of more than 700 films, including “Pulp Fiction” and “Good Will Hunting,” have tightened to around 2 percent from 6.3 percent when they were sold in 2011, ABS traders said.
“More people are buying these and more and more companies are coming to market,” said Douglas Farina, senior trader for ABS and mortgages at Loomis Sayles & Co in Boston. “And the performance of this sector is something you can’t ignore.”
Of the $199 billion of non-mortgage ABS issued in 2012, about $15 billion, or 7.5 percent, consisted of debt backed by non-traditional cash flows, according to data from IFR, a unit of Thomson Reuters.
In 2011, esoteric ABS comprised 6.3 percent, or $7.9 billion of all ABS issued. In 2010, it was 5.3 percent, by IFR data. It reached close to $30 billion a year before the 2007-2009 financial crisis, according to Barclays.
Most ABS are bought on behalf of large institutional investors such as insurance companies or pension funds that need stable, investment-grade bonds that offer decent returns.
Bowie & Beyond
The practice of securitizing offbeat income streams took root in the late 1990s, when rock star David Bowie raised money by issuing bonds backed by future royalties.
The Bowie bonds paved the way for securitizing everything from film licensing rights to the royalties from drug patents.
The 2007-2009 financial crisis, however, saw investors shy away from the sort of Wall Street engineering that made these bonds possible as defaults soared on the subprime mortgages that were often used as collateral.
“It was very difficult (after the crisis). Some guys would approach us very quietly to plug a deal and say, ‘how much can you take, can you fund the whole thing,'” recalled Farina. “Whereas now, they put it out in the market and it goes four or five times oversubscribed.”
Iconix, which owns 31 brands and trademarks, including the “Peanuts” cartoon characters, London Fog and Ed Hardy apparel, increased a transaction last year from $500 million to $600 million to satisfy investor demand.
“From 2007 to 2011, no one pitched securitization to us, but we’ve seen this market come back,” said Iconix founder and CEO Neil Cole, who said deals for fast food chains Domino’s and Sonic convinced him to raise more money through ABS.
Of course, the more off-beat the cash flow, the higher the credit risks, which means investors have to analyze the securities closely before buying.
Even the Bowie Bonds suffered ratings downgrades in the early 2000s as sales of recorded music fell and online music sharing and downloading services gained in popularity.
Farina said he steers clear of more unpredictable and less liquid issues such as bonds backed by drug royalty cash flows–risky because “you know when the patents expire but you don’t know what kind of drug will come down the pike that’s better.”
But some popular esoteric ABS, such as those backed by timeshare loans, sailed through the recession, said John Bella, co-head of U.S. ABS ratings at Fitch Ratings in New York.
“You might think that in a recession, consumers would balk at paying these loans, but they performed at or better than expected,” he said.
The different risk profiles mean esoteric bonds are rated at the lower end of the investment grade scale, which accounts for the higher yields. Buyers of timeshare ABS, for example, are exposed to both loan default risk as well as the risk of the timeshare developer or resort falling into financial trouble.
Risk & Returns
The promise of higher returns has helped bring out potential buyers, sparking unusually high demand in secondary markets for assets that in the past were treated as buy-and-hold securities.
For example, Domino’s sold $1.575 billion in 6-1/2-year, BBB-rated bonds late last year at a yield of 5.25 percent. A seven-year U.S. Treasury note yields 1.42 percent, while the average U.S. investment grade corporate bond yield stood at 2.86 percent, according to the Merrill Lynch bond index.
Since then, those bonds have traded at around 3 percent, according to ABS traders.
“Given the yield environment in fixed income, investors are increasingly looking for places with attractive relative value where they can pick up yield,” said Cory Wishengrad, co-head of securitized product origination at Barclays.
As with high-yield and investment grade corporate debt, yields have fallen on new issues. By late 2012, some esoteric bonds that might have yielded around 7 percent just after the crisis were fetching 3-4 percent or less, depending on the rating.
With average lives of anywhere from three to 10 years, that’s still a better deal than comparable U.S. Treasuries, which yield between 0.40 percent and 2.02 percent, or more mainstream ABS, such as three-year AAA-rated bonds backed by prime auto loans, which can yield as low as 0.75 percent.
Even so, some worry that this relatively small market is getting too crowded.
“The bloom is off the rose somewhat,” said John Dunlevy, a 25-year ABS veteran, now an independent consultant. “What you could see in an environment like this is a flight to quality and liquidity. Those who stay in ABS may move up and buy more traditional stuff like credit cards and autos.”
Indeed, liquidity could dry up quickly if the broader U.S. or global economy stumbles. Economists worry that higher taxes and lower spending in the United States could slow growth later this year, as could a return of Europe’s debt crisis.
And a weaker economy could raise worries about collateral.
“Some of these represent wonderful buys, but you’ll never be able to sell them to anyone else” if market conditions worsen, said Dan Fuss, Loomis Sayles vice chairman and manager of the Loomis Sayles Bond Fund.
Some in the industry are hoping to conquer a new frontier with “sunshine-backed bonds,” securities backed by the leases for roof-mounted solar energy panels, but they have been slow to take off, partly due to credit concerns at the ratings agencies.
For investors who can analyze esoteric bonds on a case-by-case basis, there’s still value to be had, said Colin Moore, chief investment officer at Columbia Management, which oversees $340 billion.
“If you are able to analyze the underlying cash flow, than the bonds can be pretty attractive.”