June 13 (Bloomberg) -- In response to rising default rates on subprime U.S. auto loans, bond investors are deciding the best thing to do is pile into securities backed by the debt.
In the market where auto loans to people with spotty credit are bundled into bonds, the difference in yield between the lowest-rated securities and the safest has narrowed to the least since August 2007, according to Wells Fargo & Co. data. Demand for the bonds is translating into cheap funding for lenders, allowing them to make even more loans though payments more than 60 days late are on the increase.
Investors are turning to riskier debt to boost returns as stimulus measures from central banks around the world suppress interest rates. The European Central Bank last week became the first to take one of its main rates below zero, underscoring the lengths to which policy makers are willing to go to jumpstart growth more than five years after the worst financial crisis since the Great Depression.
“People have to reach further and further,” said David Schawel, a money manager at Square 1 Bank in Durham, North Carolina. “The objective now is to reach a certain yield target instead of feeling good about the underlying credit.”
Yields on subprime auto-loan bonds rated BBB have fallen to within 65 basis points of those ranked AAA, down from 124 basis points a year ago, Wells Fargo data show. A basis point is 0.01 percentage point.
Issuance of securities backed by the debt has reached $10 billion this year, up 5 percent from the pace in 2013 through May 30, according to Wells Fargo. Total sales of $17.6 billion last year were more than double the $8 billion sold in 2010, when securitized-debt markets started to revive after all but shutting down amid the 2008 financial crisis.
Aided by low interest rates, the U.S. auto industry has been one of the bright spots of the economic recovery. Vehicle sales rose 11 percent to 1.61 million in May, bringing the annualized pace to 16.8 million, the most since February 2007, according to researcher Autodata Corp.
The economy contracted at a 1 percent annualized rate from January through March, the first decline in three years. An unexpected drop in spending on health-care services means gross domestic product probably shrank even more in the first quarter, according analysts at JPMorgan Chase & Co. and Pierpont Securities LLC.
Investors are increasingly willing to look at smaller, less-established firms in the subprime auto segment to boost returns, Wells Fargo analyst John McElravey said in a telephone interview.
Tidewater Motor Credit, a Virginia Beach, Virginia-based lender, sold $145 million of bonds last week that are backed by 7,438 loans carrying interest rates ranging from 9.45 percent to 26.55 percent, deal documents show. The transaction marks the first asset-backed bond offering for the company since 2012, according to data compiled by Bloomberg.
GM Financial Inc., the subprime lender acquired by General Motors Co. in 2010, boosted its asset-backed bond sale by $200 million earlier this month to $1.4 billion in its largest such offering since 2007, according to data compiled by Bloomberg.
Bond investors were paid a yield of 120 basis points more than the benchmark swap rate to buy the bonds rated BBB and maturing in four years in the June 3 sale. That compares with a spread of 175 basis points on similar debt sold in November.
The subprime auto segment has ballooned since contracting following the financial crisis. Private-equity firms, attracted by the high margins, have flocked to the business during the past three years. New York-based Blackstone Group LP acquired Irving, Texas-based subprime lender Exeter Finance Corp. in 2011, the same year that Perella Weinberg partnered with CarFinance Capital LLC.
The influx of new players to the business has fueled concern that companies are lowering underwriting standards to win business.
“Subprime auto lending from banks, captive finance companies and credit unions continues to increase and is pressuring more traditional subprime lenders to lend to ever- weaker borrowers to maintain lending volumes,” Moody’s Investors Service analysts led by Peter McNally wrote in a January report.
The percentage of subprime auto loans that are more than 60 days late rose to 2.75 percent in March from 2.24 percent a year prior, Standard & Poor’s said in a report last month, citing the latest available statistics. The delinquency rate on loans to the most creditworthy borrowers was about flat at 0.28 percent.
Defaults on the debt are climbing as the segment reaches an “inflection point” with borrowers falling behind and loan terms easing, S&P analyst Amy Martin said in an interview in March.
Losses on the debt, though still within expectations, jumped to 4.45 percent in March from 3.88 percent a year earlier, according to S&P.
Some lenders are pushing back against deteriorating underwriting standards, becoming less willing to extend loans to increasingly risky borrowers, according to Moody’s. Borrower credit scores for used car loans improved in the fourth quarter of 2013 for the first time since 2010, the rating company said in an April report.
Lengthening loan terms and rising debt burdens relative to the value of a vehicle show that lenders are still taking on more risk, the Moody’s analysts led by McNally wrote in the report.
Top-ranked securities linked to the debt are yielding 45 basis points more than the benchmark rate, compared with 36 a year ago, according to Wells Fargo. Bonds rated BBB, two steps up from non-investment grade status, are 110 basis points more than swaps, down from 160, the data show.
New-loan volumes are likely to remain high in the subprime auto segment at least through 2015 even as some lenders pull back, according to Moody’s.
“Since lenders will still continue to vie for borrowers, we don’t expect a major slowdown in subprime lending,” the Moody’s analysts said. “Competition will continue to pressure the credit quality of new originations as lenders fight for business.”
--With assistance from Carlos Torres in Washington.