Tailwinds helping the ABS market Tailwinds helping the ABS market http://www.federatedhermes.com/us/static/images/fhi/fed-hermes-logo-amp.png http://www.federatedhermes.com/us/daf\images\insights\article\cars-on-lot-small.jpg July 31 2025 July 31 2025

Tailwinds helping the ABS market

High used car prices and low unemployment are positive for investors.

Published July 31 2025
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The biggest sector of the asset-backed securities (ABS) market is auto-related. Within it, the two main sub-sectors are loans and leases. They have distinct features, but both are faring well in the current climate. The primary drivers of performance are high used car prices and low unemployment.

The Manheim used vehicle value index shows used car prices have risen more than 16% since January 2021. Auto website Edmunds.com says that factors such as the Covid-era chip shortage have resulted in a market in which “years of low new-car sales now have used car shoppers feeling the effects of a used vehicle inventory shortage.” This strength helps to mitigate the risk that a default will lead to losses for investors. If borrowers default on their loans, the elevated prices will lead to stronger recoveries, providing more protection to investors in securitizations.

For auto leases, high prices for used vehicles diminish or remove residual value risk. After an initial lease period (generally two-to-three years), the lessee can either return the car or buy it for a predetermined amount, called a contract value.

The risk faced by investors in auto-lease securitizations, in which 60-70% of the ABS deal can be based on the residual value of the underlying vehicles, is that the market value upon lease return will be less than that predetermined amount. Current prices address that problem. With used car prices high, more drivers tend to want to buy their car at the end of the lease, compared to historical return ratios, thus eliminating the residual risk entirely for those vehicles. Even if a lessee doesn’t buy the vehicle, the market value of the car is likely to be high enough to cover the contract value.

Both loans and leases are helped by today’s low unemployment rate, which positions customers well to make payments.

Prime versus subprime

We are starting to see a distinction between the higher-end prime borrowers and the subprime market. For prime, these are good times. By contrast, subprime is fraying a little bit.

Basically, ABS are structured with senior tranches, typically AAA-rated, that are best insulated from losses from default. Additional tranches, typically rated below AAA down to BBB-, are subordinated to the senior tranches. Finally, an equity tranche at the bottom faces the most risk and the most potential reward. The servicer of the loan typically holds these.

As a group, subprime continues to do well, thanks to the robust labor market. Still, inflation and high interest rates have taken a toll on subprime borrowers, where we’ve seen an increase in delinquencies and charge-offs. Still, this remains contained for now. The capital structure of the ABS tends to minimize such problems for debt investors and most deal tranches can withstand almost twice the worst collateral losses that securitizations have experienced.

Subprime credit cards and personal loans are areas that would face the potential for more losses if the lower-end consumer began to struggle more. A possible solution is to buy only prime credit cards, for which gross yields are historically high and charge-offs are historically low. These are some of the best credit card metrics we've seen in decades.

Tags Fixed Income . Markets/Economy .
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Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.

Manheim Used Vehicle Index: An independent measurement of prices based on monthly sales of used vehicles in the U.S.

The value of some asset-backed securities may be particularly sensitive to changes in prevailing interest rates, and although the securities are generally supported by some form of government or private guarantee and/or insurance, there is no assurance that private guarantors or insurers will meet their obligations.

Bond prices are sensitive to changes in interest rates, and a rise in interest rates can cause a decline in their prices.

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