Sector Spotlight — Investing in Student Loans
- 06 mins 24 secs
MFS municipal investment professionals discuss rising levels of student loan debt and factors to consider when investing in student loan bonds.
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- Today, roughly 40 million Americans owe one point six trillion dollars in student loan debt, surpassing all other segments of consumer debt, aside from mortgages. The burden of student debt is a thread that runs through every city and state in America, and one that has become a hotbed of political debate. Why has student loan debt tripled over the past decade? Why are more than 30% of federal student loan borrowers having trouble making payments, and how have these increasingly negative headlines created opportunities for municipal investors like MFS? All questions that our resident experts, municipal analysts, Dan Streppa and Matt Whorisky are here to help us understand. So, Dan, how did we get here?
- So, Brad, it's important to keep in mind that the federal government is focused on maximizing access to education, not on making loans to credit-worthy borrowers. And there are obvious trade-offs between those two objectives. On the other hand, demand for student loans has been driven by rising tuition costs, societal shifts toward attending college, and, in the aftermath of the last recession, an influx of older, non-traditional borrowers seeking new skills. So the answer to why we've seen such tremendous growth in student loan debt really lies in the simple fact that there's incredible demand for it and the federal government has been happy to supply it.
- But why are borrowers having trouble repaying their debt?
- Sure. So, research suggests that in the aftermath of the financial crisis federal loan dollars were increasingly used to fund education at for-profit universities and two-year community colleges, which have lower graduation rates and higher default rates than traditional four-year schools. At the same time, the types of high debt burdens that had historically been associated with lucrative professions such as medicine or law, have become increasingly common for undergraduate borrowers. So, while these borrowers will ultimately graduate and find employment, their incomes are often insufficient to provide a return on the significant investments that they've made in their education.
- So, for us as investors, the key takeaway here is that student outcomes drive repayment and default rates, and default rates are markedly higher for federal loans, which is the private student loans that we have the opportunity to invest in in the municipal market.
- So, anytime there's a demand for something, the government's more than happy to step in and supply that. You mentioned private student loans. Can you talk about the differences between federal student loans and private student loans?
- The key distinction with federal student loans is, one, they don't require a credit check co-signer, which private student loans do. Two, private student loans have stringent income and FICO score requirements, to weed out riskier borrowers. And, three, private issuers limit borrowers from attending for-profit schools that tend to have poor student outcomes. So, given these distinctions, the large disparity between federal and private student loans isn't very surprising.
- And after they originate these student loans, state-affiliated student loan agencies will pull the loans and issue bonds back to buy their cashflow. They'll typically issue fewer bonds than the value of the underlying loans, and this creates over-collateralization that serves to protect bond-holders from losses on the underlying loans.
- So you have more loans, or assets, that are paying into the bond structures than bond payments or liabilities that are coming out of it. Is that correct?
- Exactly. And that's what creates that cushion.
- So, outside of over-collateralization, what other criteria are you looking at when you're analyzing these bonds?
- So, one thing that Dan and I pay very close attention to is to the schools that these borrowers are attending. We view low retention and graduation rates as a leading indicator for difficulty repaying debt, and we also screen for weaker schools with poor student outcomes. For example, Dan and I recently reviewed a Pennsylvania student loan transaction. From my experience as a higher education analyst, I'm aware that Pennsylvania schools face severe demographic challenges, and are comparatively weaker. For these reasons, we viewed exposure to these schools as a negative for the credit quality of the loan pool.
- On the other hand, another transaction that we recently reviewed was being used to fund refinanced loans to borrowers that had already graduated from school and on average were making $150,000 a year, factors that bode pretty well for their ability to repay that debt. In fact, we have to consider the possibility that some borrowers might opt to pre-pay their loans, which would result in the bonds that are associated with that loan being paid down prior to maturity. So, in addition to all this credit analysis, we're also analyzing the impact that the timing of payments has on a bonds valuation.
- So, not just good enough to get the credit right, you also have to look at the pre-payment risk as well.
- So, we actually are already in a fully-charged political season, and I know politics play a role in these bonds. Can you talk about what you analyze when you're looking at these bonds as it pertains to politics?
- I've seen most focusing on reforms to income-based repayment programs that we currently have in place, and there's also some discussion about changing the current bankruptcy laws to allow student loan borrowers to discharge those loans when they enter bankruptcy, which is currently extremely difficult to do.
- Right, and just as an add-on, Dan, even if student loan debt could be discharged in bankruptcy, the co-signer requirements that we have on our private student loans that we own offer significant protection. Not only would the student loan borrower have to declare bankruptcy, but their cosigner would as well, which we view as unlikely. And additionally, at MFS, we're in regular conversations with bankers, issuers and other industry experts, to keep us updated with new developments on Capitol Hill, to stay ahead of the curve.
- Well, you guys are going to be busy. It sounds like there's a lot to analyze here, and I want to thank you very much for coming down and sharing your insights today. Changes to the US bankruptcy laws and shifting political sentiment are important macro-factors we monitor at MFS. But we think it's equally important to do the bottom-up work, of analyzing the student outcomes and pre-payment complexities of individual issuers, to strive to make the best investments for our clients. Municipal student loan bonds without a doubt have elevated risks, but that's why you hire an active manager, to cut through the political narrative and uncover value for investors. Thanks for listening.
The views expressed are those of the speaker and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as a solicitation or investment advice from the Advisor.