How to navigate the subprime ABS market

Last month, a lender in subprime auto loans went bankrupt. The event is instructive about not only current economic conditions but also gross mismanagement. It’s important to see it in perspective. The issuer, Tricolor, provided loans to undocumented immigrants with no tax ID numbers and no FICO scores. In fact, more than two-thirds of the loans they originated were to this group of borrowers, many of whom did not even have driver’s licenses. The company had been cited more than 100 times for selling cars for which it didn’t hold a title and is under investigation for potential fraud related to double pledging collateral. This is not representative of how the vast majority of auto lenders operate, whether they cater to prime or subprime customers. But it underscores the importance of diligence. 

Recent discussions around a K-shaped economy highlight the growing divide between affluent households and those struggling with inflation. Core household expenses have risen sharply in recent years, while wage growth has lagged—particularly impacting lower-income consumers. Auto loans have become especially burdensome, driven by elevated interest rates and rising vehicle prices.

This pressure is evident in the subprime auto loan market. Over the past five years, we've observed performance deterioration across both prime and subprime borrowers. For prime borrowers, this trend largely reflects a normalization toward historical delinquency and default rates. However, subprime borrowers have not only moved beyond their previously low delinquency levels but have continued to deteriorate past historical norms, now exceeding prior peak loss levels. It's important to note that this trend reflects the broader market and not necessarily the issuers we approve and invest in.

A key driver of this stress is the cost of vehicles themselves. New cars now average around $50,000, and used vehicles exceed $25,000. Nearly 20% of new car buyers face monthly payments over $1,000. With loan terms often stretching six to seven years, many borrowers remain underwater for much of the loan's life. As a result, higher-risk borrowers are defaulting more frequently, and when they do, the resulting losses are larger due to higher asset values.

Discipline is key 

Our disciplined investment strategy helps ensure we remain focused solely on bonds backed by reputable and well-established underwriters and servicers in the subprime auto loan sector. Moreover, these issuers have benefited from diversified funder sources—including equity, corporate debt, warehouse lines, and deposits—alongside their ability to access the asset-backed securities (ABS) market. 

We believe the subprime deals we invest in are structured with exceptional resilience. Typically, BBB-rated tranches feature credit enhancement levels that are approximately double the worst-case collateral losses observed during the Global Financial Crisis. Notably, bonds issued by these vetted and approved entities have shown the ability to consistently return full principal without any impairments to date—despite operating under the same challenging market conditions as their peers. This further underscores the rigor and discipline we apply before approving ABS bond issuers.