Tariffs on vehicles might supercharge auto ABS

The financial world is full of seemingly contradictory elements. Bonds rally when their yields drop; a weak currency can be good for a country; deflation and inflation can both harm an economy. Recently, the automotive slice of the asset-backed securities (ABS) market has exhibited its own unintuitive characteristic, due in large part to the Trump administration’s new tariffs.

President Trump has imposed a 25% tariff on new vehicles and certain auto parts. Analysts expect this to raise the cost of new autos as manufacturers pass on the increased expenses to consumers. While the tariff does not directly target the used market, the impact on new car prices, consumer demand and production patterns will inevitably ripple through to this subsector.

One significant potential consequence is a reduction in the supply of new vehicles. Manufacturers may adjust their production strategies, possibly shifting operations to produce higher-margin vehicles in the US. This could result in fewer new automobiles, trucks and the like, and those that are built might be priced at a premium. As affordability becomes a concern for buyers, the demand for used vehicles is likely to rise. In theory, that should increase demand and, consequently, sticker prices.

These developments have implications for ABS tied to auto loans and leases. As used vehicle costs rise, so do residual values in lease agreements and recovery rates in loan deals. For leases: higher residual values mean that, when a vehicle is returned at the end of its term, it may sell for more than originally anticipated, resulting in residual gains. In addition, leaseholders often can purchase their vehicle at the conclusion of the lease term. An increasing number of them are doing so, especially if their vehicle’s market value exceeds the predetermined residual value. This is resulting in a lower turn-in rate, which benefits bondholders by effectively eliminating residual value risk. For loans: if a borrower defaults and the vehicle is repossessed, the proceeds from its sale should contribute to the recovery for ABS bondholders. Higher resale values reduce the severity of losses on defaulted loans, leading to lower cumulative net losses in the collateral pool.

This shift is already underway. As new vehicle prices climb, a segment of buyers is being priced out and is instead seeking more affordable used options. The used car market is already constrained due to the lingering effects of the pandemic, which significantly reduced vehicle production. This shortfall has in turn limited the supply of pre-owned vehicles. So, if manufacturers limit their production further, the imbalance between supply and demand could worsen.

Evidence of these trends is visible in market data. The Manheim Used Vehicle Value Index, which tracks over five million used vehicle transactions annually, has shown a notable increase since the tariffs were announced. In April, it rose by 4.9% compared to the previous year and by 2.7% from March. Another indicator of rising demand is the average number of days it would take to sell the current supply of used cars at the existing sales pace. As of the end of April, this figure stood at 41 days, down from 46 days a year earlier.

It may not be intuitive, but all else being equal, what upsets car buyers will likely benefit holders of ABS backed by auto loans or leases.