Rob Almeida:

My name is Rob Almeida, chief Investment Strategist and portfolio manager at MFS. Welcome to another edition of Strategist's Corner podcast.

Speaker 2:

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 an offer of securities or investment advice. No forecast can be guaranteed, past performance is no guarantee of future results.

Rob Almeida:

In this episode, I'm thrilled to be joined by two members of MFS's asset-backed securities team, Phil Burgener, and Qi Guan, where we discuss their market, and the signals it provides about the health of the consumer, the economy, and a whole bunch of other factors, and I hope you enjoy.

So before we delve into the ongoings of your space, maybe demystify or simplify it a little bit for us. What are asset-backed securities? Who's providing the financing? Who's asking for capital? Who are the borrowers? Who are the lenders? How does this work?

Qi Guan:

So asset-backed securities is, in very simple terms, just think of it as a security that's backed by a pool of assets, such as your car loans, your student loans, your credit card receivables, or if you get a phone upgrade that when you pay your data provider throughout two years, that payment is being secured as-

Rob Almeida:

So my monthly Verizon bill?

Qi Guan:

Right, basically.

Rob Almeida:

Okay. Got it.

Qi Guan:

And those cash flows that you pay on a monthly basis will be used to pay back ABS investors who purchase the bonds-

Rob Almeida:

Yeah.

Qi Guan:

Such as investors like us.

Rob Almeida:

So investors like you, you're financing that, so maybe walk me through the mechanics of it. Are banks securitizing those loans to you in the form of packages that you are buying? How does that work?

Qi Guan:

So just to give a really quick example, think of the asset-backed security just like a company. So for example, in a bank that originates credit card loans, they will bring thousands and thousands of loans, and put them in a trust, what we call a trust that's a dedicated trust with a pool of credit card loans. And once they package those together, they will issue an asset-backed security that's backed by this pool of credit cards receivables.

Rob Almeida:

Yep.

Qi Guan:

And those will be kind of categorized into different tranches like class A, class B, class C, and then depending on the investors risk appetite, and they will decide whether they want to buy the class A, the class B, or class C.

Rob Almeida:

So regarding the different classes, what determines that risk profile for each of those classes? How does that work?

Qi Guan:

So in a structure, so when we want to talk about class A, B and C is basically one aspect is time trends, so the class A will be the first one to receive all the cash flow before the class B, and once the class B gets paid back, and then you get to the Class C-

Rob Almeida:

Got it.

Qi Guan:

And in terms of losses, that the class C will be the first one to absorb any losses that come in through to the trust, and that's going in reverse. So the class A, they'll get all the money back first, and the class C will get the money last, but in terms of losses will be reversed.

Rob Almeida:

Got it. So in summary, this market, this industry, it's a means for banks in-

Qi Guan:

Like private companies-

Rob Almeida:

Yep, lay off that risk.

Qi Guan:

Yeah, captive, any kind of high-yield investment-grade company, you can have small company that just originates one type of loans, for example, like car loans, and ABS provides them an efficient way of funding-

Rob Almeida:

Yep.

Qi Guan:

For their business, basically.

Rob Almeida:

Right.

Qi Guan:

And this is a cheaper way of funding for them, versus going to the bank and get a loan, or warehouse loan that could cost them significantly more.

Rob Almeida:

So then as an investor, you're analyzing the pool itself-

Qi Guan:

Right.

Rob Almeida:

The quality of the borrowers, potential for cash flows, then you're decomposing which classes offer the best risk/return-

Qi Guan:

Risk/reward, right.

Rob Almeida:

And then Phil, then you're deciding as a generalist?

Phil Burgener:

Correct. And to demystify it further, we think about securitization, or the markets due as a black box, what is it? But our approach is no different than a corporate analyst looking at an investment-grade company or a high-yield company. We have a pool of assets, let's say they're car loans, Qi's example, and we're forecasting the future cash flows from those assets.

Rob Almeida:

Yeah.

Phil Burgener:

How many borrowers will default between now and the end of their life for their loan.

Qi Guan:

Right.

Phil Burgener:

Then we take those cash flows just like a corporate analyst is predicting revenue and predicting EBITDA out for years, to figure out how much that can service or debt and leverage ratios, we're taking those cash flows, and we're running through it at the bond structure-

Rob Almeida:

Yeah.

Phil Burgener:

And we're looking for that inflection point where we think we're getting paid enough spread given the risk associated with that portion of the tranche.

Rob Almeida:

Yeah.

Phil Burgener:

And if a borrower doesn't pay their car payment, we repossess that vehicle, the trust does, and those recovery proceeds are passed through to a trust. So, Rob, my advice to you is stay current, or we're getting your car.

Rob Almeida:

Yeah-

Qi Guan:

And we don't have to provide you any notice-

Rob Almeida:

Yeah.

Qi Guan:

We'll come and just get your car.

Rob Almeida:

And my motorcycle-

Phil Burgener:

And motorcycle.

Qi Guan:

Yeah.

Rob Almeida:

My RV, my boat-

Phil Burgener:

Your phone-

Rob Almeida:

I don't have any of those.

Phil Burgener:

Your phone, right?

Rob Almeida:

Yes.

Qi Guan:

Your phone.

Rob Almeida:

Someday I'm going to get a phone, I heard they're in. So Phil, that's a good point. So staying on that demystify, you've got new issue asset-backed securities, and then you have, I guess you want to call them off-the-run.

Phil Burgener:

Sure.

Rob Almeida:

So once it becomes off-the-run, does the analysis change?

Phil Burgener:

The analysis doesn't really change. Now we have performance data, how have those loans performed? How have those cash flows performed over the first six, 12, 24 months?

Qi Guan:

Right.

Phil Burgener:

Whatever the time period is.

Rob Almeida:

Right.

Phil Burgener:

Qi, or the analysts covering that particular security would then dig in, what does a loan pool look like today?

Rob Almeida:

Yep.

Phil Burgener:

How do we predict cash flows in the future? And then exactly, again, what corporate analysts do as well-

Rob Almeida:

Right.

Phil Burgener:

Is, taking those predicted cash flows, how many widgets are you selling? How many loans are continuing to pay their auto loans back? And running those cash flows in the structure.

Rob Almeida:

Right, right.

Phil Burgener:

So it's really important to take a step back, I understand, global financial crisis, the complexity of securities, but our approach here at MFS is no different than we approach any other investing. It's about fundamentals-

Rob Almeida:

Yeah.

Phil Burgener:

The durability of cash shows, and our ability as analysts, the credit team, to predict those cash flows in the future.

Rob Almeida:

Right.

Qi Guan:

Right.

Phil Burgener:

The structure is secondary.

Qi Guan:

Right. If you really think about it, it's no different from, think of an ABS almost just like a bank.

Rob Almeida:

Yeah.

Qi Guan:

We have assets, we have liabilities-

Rob Almeida:

Right.

Qi Guan:

Within the structure. And the only difference is this structure does not continue to make loans, whereas the bank does.

Rob Almeida:

Right. No, and that's a really good point, and that's something that I've been trying to communicate in this really difficult volatile year, 2022, is that the purpose of investing your intermediating between savers, those with excess capital, and a corporation, an enterprise, a government, and municipality, someone with a project or idea, but you're funding cash flows, and your asset class isn't any different, and what's the probability of those cash flows living up to expectations, right?

Phil Burgener:

Exactly.

Qi Guan:

Right.

Phil Burgener:

No different than predicting revenue EBITDA for a corporation-

Rob Almeida:

Yeah.

Phil Burgener:

Out five, 10, 15 years.

Rob Almeida:

And so regardless of what the sticker might say, AAA, AA, A, I mean, you have to do that homework.

Qi Guan:

Right.

Phil Burgener:

We do that homework for every-

Qi Guan:

Right.

Phil Burgener:

Single investment that we participate in.

Qi Guan:

Yeah. I think we do the homework on the whole structure, not just looking at a particular tranche, or-

Rob Almeida:

Yeah. You start off with the pool.

Qi Guan:

Yeah, we start off with the pool if we actually like the whole transaction, and instead of just, "Okay, I'm just going to buy the class A, I'm just going to target my analysis to the class A." That's not true, we perform the analysis on the whole transaction if we're comfortable buying all the way down to whatever class A issue, and then we kind of pick which one we think would suggest a reward in terms of spread.

Rob Almeida:

It makes sense. So before we get into what your market's signaling today, and its impact on the economy, and those other sorts of things, last question, without giving away the secret sauce, if you will, but what are some of the key things that you look for, or that you look to avoid, if there are any?

Qi Guan:

Obviously, you don't want to own the bond, and it end up losing money, obviously.

Rob Almeida:

Sure. Yeah, yeah. That's bad.

Qi Guan:

That's the primary purpose-

Phil Burgener:

That's bad.

Qi Guan:

And do our analysis. They wouldn't think that we really look as for how good analysis to project in those cash flows. And every couple months we assess how well our initial analysis is, and then I take the information that we get in the past couple months and we assess that scenario.

Rob Almeida:

So you're looking for thesis drift.

Qi Guan:

Right-

Rob Almeida:

The same idea.

Phil Burgener:

And that's a really good question, Rob, because what we do, and our approach, and I've learned this from investing in this space through the global great financial crisis, however you want to name it, is structure is only as important as a quality of the underlying-

Rob Almeida:

[inaudible]

Phil Burgener:

Assets, and the durability-

Qi Guan:

Yeah.

Phil Burgener:

Of those cash flows through cycle.

Rob Almeida:

Yeah.

Phil Burgener:

The structure will never save you. It will help your rating stability-

Qi Guan:

Right.

Phil Burgener:

It will help your weighted-average life profile, but if you have to rely on that structure because the quality of your assets are so subpar, or the originator and sponsor is someone we can't get comfortable with, it's a pass.

Rob Almeida:

Yeah.

Phil Burgener:

That is unique in our approach versus the market, because what we are seeing today, and in the past couple years, and Qi can attest this probably better than I can, is we are seeing so many various issuers, first-time issuers, low quality management teams, low quality origination platforms are servicing platforms, all red flags to us. But they take these assets, they put a structure on top of them, and they say, "You can run your loss projections, this bonds will hold up." We don't invest in those structures.

Qi Guan:

No.

Rob Almeida:

Yeah.

Phil Burgener:

We don't invest in those companies, we don't invest in those assets, because our belief is, we want the good management teams, we want the quality assets, we want to have visibility of what we believe those cash flows will look like. We need trust, we need-

Qi Guan:

Right.

Phil Burgener:

To have that relationship with -

Qi Guan:

Yeah.

Phil Burgener:

…the sponsor.

Rob Almeida:

So going back to that, is that a function of economic excess, money supply, that increase in maybe lower quality origination? Or is that-

Phil Burgener:

Without a doubt. At one point it was a reach for yield, a reach for spread.

Rob Almeida:

Okay.

Qi Guan:

Yeah.

Phil Burgener:

I would say it's the second half of 2020, early 2021-

Rob Almeida:

Yeah.

Phil Burgener:

We saw first-

Rob Almeida:

So investment demand was driving asset supply?

Phil Burgener:

Absolutely.

Qi Guan:

Right.

Rob Almeida:

Okay, okay.

Phil Burgener:

We saw first-time issuers issuing assets that we wouldn't feel comfortable owning, and we don't think we have a better than market ability to predict what those cash flows will look like through a cycle.

Rob Almeida:

Right.

Qi Guan:

Yeah.

Phil Burgener:

You have a lot of unsecured loans for first-time issuers, a lot of private companies-

Phil Burgener:

Very small companies. And again, it's that insight, it's the ability to do work, not just on the structure and collateral, but have conversations with the management team, understand their origination profile-

Rob Almeida:

Yeah.

Phil Burgener:

Their profitability, what's their alignment of interest? These are all-

Rob Almeida:

Yeah.

Phil Burgener:

Parts of the investment process that we utilize to get comfortable and securitized.

Rob Almeida:

It is amazing, not to suggest that this is anything like the GFC, we're going to get into that, but how history does repeats, and cycles do repeat, and the market makes its own supply.

Phil Burgener:

Yes.

Rob Almeida:

So you were both at an industry conference, I think a few weeks ago, meeting with dozens of management teams, and companies, and issuers. So compare/contrast, because you both presented at a financial services sector meeting a few months back, and some of the highlights I remember, consumer balance sheets, healthier versus GFC, consumers were paying down credit cards at a very fast pace, delinquencies were low. What are you seeing and hearing now versus then?

Qi Guan:

So a couple months ago when we first did the presentation at the financial services, I mean, one thing hasn't changed is that majority of the consumers are still in a pretty good shape today-

Rob Almeida:

Yeah.

Qi Guan:

They're still paying down their debt, but the tone of the lender has actually changed. So if we were to ask them, "What are you concerned about? Are you concerned about inflation? Are you concerned about how high rates will affect your business as well as your consumers?" I think a couple months ago no one had any concern. When we kind of point to, "Do you see anything in performance that kind of concerns you?" And-

Rob Almeida:

Performance of the loans?

Qi Guan:

Of the loans, yes.

Rob Almeida:

Yep.

Qi Guan:

Because of high inflation, and high rates. And all of them say, "No, everything's just normalizing." But at the conference, we're start to see lenders becoming a little bit more concerned-

Rob Almeida:

Yeah.

Qi Guan:

And they're watching closer, and without exception of all the lenders which spoke with that they have tied in underwriting standards.

Rob Almeida:

Okay.

Qi Guan:

So there are some changes that they are seeing, small changes-

Rob Almeida:

Yeah.

Qi Guan:

That they are seeing, that kind of concern them, to a point that they kind of pull in lending-

Rob Almeida:

So to Phil's point, maybe the quality of the issuance is getting a little better. Is that the right read?

Qi Guan:

In the newer origination, yes, you would.

Rob Almeida:

Yes, correct. Yeah, yeah, yeah.

Qi Guan:

Yes, yes.

Rob Almeida:

Yeah.

Phil Burgener:

So I think Qi did a really nice job in this, we all hear about headline inflation numbers, CPI seven, 8%. But when we really think about it, how does that impact your household? Not every household is going to fit in one category, you're going to have prime households, you're going to have more middle class, you're going to have lower income households. Qi took a look at that, and we drilled down using, again, a lot of this loan data that we get through the securitization trust, with a lot of the conversations of different originators, and back of the envelope, but you know what she kind of highlighted, I don't know if you want to highlight it, Qi, but for just shelter and transportation costs alone-

Rob Almeida:

Yeah.

Phil Burgener:

For that borrower, that consumer who does not own a home since COVID, inflation's gone up a little bit north of 20%-

Qi Guan:

Right.

Phil Burgener:

Over the last three years.

Rob Almeida:

That's brutal.

Phil Burgener:

It is brutal. For the prime consumer, it's gone up over that same period-

Qi Guan:

Yeah, kind of in the teens, but significantly lower-

Phil Burgener:

Lower-

Qi Guan:

Compared to-

Phil Burgener:

I think it was 12, 13%-

Qi Guan:

Right.

Phil Burgener:

Over three years. That's manageable-

Rob Almeida:

Yeah.

Phil Burgener:

Given what we know about wage inflation. But for that middle class cohort that doesn't own a home-

Rob Almeida:

Yeah.

Phil Burgener:

To see that type of inflation is really eye-opening. So again, it's digging down and going beyond the headline number, but thinking about, how does that impact what we're buying in securitized?

Rob Almeida:

Right.

Phil Burgener:

But also, what I love about the platform we have here, the research platform, is how plugged in we are in the entire-

Rob Almeida:

Yeah.

Phil Burgener:

Research ecosystem-

Qi Guan:

Right.

Phil Burgener:

And taking that information and presenting to the financial services group, talking to the retail analysts, and saying, "Hey, this is what we're seeing-"

Rob Almeida:

Yeah.

Phil Burgener:

"Something to be cautious on, or talk to your management teams-"

Rob Almeida:

Yeah.

Phil Burgener:

"And see if they're hearing the same story."

Phil Burgener:

We're talking to issuers, some are private, some are Fortune 500 companies, they can be in the same industry. The information you get from a private company who is less constrained about public information, they can be really insightful on, what are they seeing in pricing power for loans? How's their loan book performing? What does competition look like?

Rob Almeida:

Yeah.

Phil Burgener:

We gather that information, and we are able to distribute it again to other analysts, portfolio managers-

Rob Almeida:

Yeah.

Phil Burgener:

Throughout the complex, whether it's fixed income or equity-

Rob Almeida:

Yeah.

Phil Burgener:

All with the purpose of helping them make better informed decisions on how they allocate capital for our clients.

Rob Almeida:

Yeah, so given that, how does that impact your probability assessment of cash flows, and the securities that you're looking at? How are you thinking about your asset class today, relative to nine months ago when it was a very different inflationary environment, and a very different consumer environment?

Qi Guan:

Overall, our team hasn't really changed, but what I would say is that given the backdrop, the probability of The U.S. economy going into a recession-

Rob Almeida:

Yeah.

Qi Guan:

Obviously no one can predict when that's going to happen, and whether it will be a deep recession, or a soft landing-

Rob Almeida:

Yeah.

Qi Guan:

So what we do is that we have moved away. I wouldn't say move away, we become a little bit more conservative in terms of even the issues we like, we are moving a little bit higher in the capital stack.

Rob Almeida:

Okay.

Qi Guan:

Not that we don't like the sponsor, but I don't think we are getting pay enough to take on that-

Rob Almeida:

Right.

Qi Guan:

Lower class risk.

Rob Almeida:

Right, yeah.

Qi Guan:

In the event we do, and we are getting compensated for it, you might experience a lot of volatility-

Rob Almeida:

Yeah.

Qi Guan:

Through the period, but if we think that we're going to pay enough, that's when we will step in.

Rob Almeida:

Yeah. Yeah, so just not different than a credit investor making decisions-

Qi Guan:

Right.

Rob Almeida:

Maybe an investment-grade credit-

Rob Almeida:

And a high yield-credit, you need to be paid, and you're not getting paid enough in one, versus the other-

Qi Guan:

Right.

Rob Almeida:

Et cetera?

Phil Burgener:

Yeah, so I'd say in consumer space, and structures that are more levered to that subprime, or middle tier consumer, we've gone up in quality-

Qi Guan:

Right.

Phil Burgener:

So where you're more inclined to look at the AAA and AAs at current valuations-

Rob Almeida:

Yeah.

Phil Burgener:

As a whole, under Qi's recommendation, we've upgraded the portfolios in general, or our recent investments, by looking more at deals that are backed by that prime consumer.

Rob Almeida:

Okay.

Phil Burgener:

Because our view, again, just judging by one of the conversations we've had down in Miami with all these different originators and issuers, and Qi's, great work, again, on that inflation component, that prime household is in remarkable shape, and the expectations are that through cycle losses will be average, or maybe even slightly below average-

Rob Almeida:

Right.

Phil Burgener:

What you typically see in a recession.

Rob Almeida:

Right, right. Which is consistent with... every recession is just a rebalance of whatever was in excess, and in '07 and '08, that was a rebalance of the banking system and the consumer. The consumer was out of balance, and rebalanced throughout the 2010s. So going into this, the consumer was in much better shape to begin with, notwithstanding the seven, eight, 9%-

Phil Burgener:

Right.

Rob Almeida:

So losses could be not as severe as you've seen in past cycles, or no?

Qi Guan:

Yeah, well, I think I would agree, one, not only consumers today are in a much better place, and they are much healthier compared to past cycles. Also, what we are seeing is lenders are also being responsible, and proactive, and actually tightening by their standards. So you have two forces kind of working together in a way-

Qi Guan:

… then if we were to hit a recession today, in terms of loss, that I believe would be lower than what we experienced in the past cycle.

Rob Almeida:

Right.

Phil Burgener:

And it's a great question, Rob, because it is an interesting reaction function from the lenders we met with down in Miami, versus if you had a similar discussion in '06 and '07. Today, when they see performance or delinquencies starting to tick up, almost universally, from all the lenders we spoke to, are pulling back credit, they're tightening standards. If you go back to '06 and '07, even though delinquencies were starting to increase, the lenders are still tripping over themselves to make loans and grow.

Rob Almeida:

Right.

Phil Burgener:

And that philosophy or that mindset, at least... It's still early days-

Qi Guan:

Right.

Phil Burgener:

But at least-

Rob Almeida:

Yeah.

Phil Burgener:

So far has changed, and they're actually being somewhat disciplined, and that is in stark contrast-

Rob Almeida:

Yeah.

Phil Burgener:

To when you go back to these same lenders back in '06, '07 leading into the crisis.

Rob Almeida:

Yeah. Yeah, and not to convert this to an economic discussion, because that's not why we're here, but it is just interesting to me that these narratives about soft landing, hard landing, you mentioned probability of recession, it's so hard to predict, we can see financial market pain with without a recession. Because the excess wasn't in the consumer, which drives 2/3 of GDP, the excess was in non-bank profit margins. To me what you're confirming is, the consumer was relatively strong going into the pandemic, we know they came out of the pandemic stronger because the stimulus, now that's faded, and I think what you're saying is the lower end's being stressed by inflation, but that prime borrower has flexibility, at least flexibility relative to other pre-recessions?

Phil Burgener:

Absolutely remarkable how strong that prime borrower is-

Rob Almeida:

Okay.

Phil Burgener:

Right now. And it was a takeaway from this conference. Again, we're down there-

Rob Almeida:

Yep.

Phil Burgener:

Qi's down there as an analyst, I'm down there just absorbing the information in sunny Miami, and I always think to myself, "What are the takeaways from a capital allocator perspective?" From a viewpoint-

Rob Almeida:

Yep.

Phil Burgener:

"What are my takeaways?" And coming out of that conference, I certainly have a different view on monetary policy, soft landing, hard landing, and the consumer. And the takeaway for me was, the prime consumer surprised me, I mentioned this to Qi-

Qi Guan:

Yeah.

Phil Burgener:

How resilient they are with this many rate hikes, this much amount of tightening, that they're still spending, they're traveling, they're using their Amex cards, they're seeing good loan growth, they're still employed. I'm surprised by that.

Rob Almeida:

Yeah.

Phil Burgener:

I would've thought they had slowed down sooner.

Rob Almeida:

Yeah.

Phil Burgener:

Now the question is, what does that tie into? Well, that tells me that despite some of the better inflation prints we may have had recently, we may still have far to go on monetary policy tightening, and the Fed may actually have cover, because the economy's still doing relatively-

Rob Almeida:

Right.

Phil Burgener:

Well because of that upper income cohort.

Rob Almeida:

Yeah. Yeah, no, and that's what I was trying to get at with my comment a moment ago, where Central Bank may still have work to do for what... Just as you're describing, and it might not be game over, if you will, from a monetary policy tightening standpoint. And that has impact in other areas of the-

Phil Burgener:

Definitely.

Rob Almeida:

Financial markets, for sure. Okay, so when we think about fixed income investing, you're obviously lending money, and you're expecting to get that money back. So from an asset allocation standpoint, so what I'm hearing, the consumer's strong, there's pockets of weakness, softness, but it's remarkable, the quality of the consumer today. If we compare that to the corporate sector, which is seemingly equally strong, but as growth fades, as revenues fades, as pricing power fades, we're likely to see some profit margin reset, and a higher probability of defaults in the corporate sector, at least relative to the asset-backed space. So thinking about it from an asset allocation standpoint, are asset-backed securities today more attractive, because there's just less default risk, relative to the U.S. corporate or corporates in general?

Qi Guan:

Asset-backed on historical basis relative to corporates are definitely more attractive today. And one of the things that, just like you mentioned, about the corporation, the margin can get compressed, and the revenue can drop in the coming quarters. Whereas in an asset-backed structure, once you have... You make the loan, you put the loan in there, it doesn't change, what changes is how the consumer behaves, how they-

Rob Almeida:

Yeah.

Qi Guan:

Will pay back your loans. So you have less factors that would impact the cash flow, other than monitoring how the consumers are doing.

Rob Almeida:

Yep.

Qi Guan:

So I think we have stronger, maybe not stronger, but we have a little bit more clarity on a static pool of loans, versus what will-

Rob Almeida:

[inaudible]

Qi Guan:

Happen to the corporations.

Rob Almeida:

Right.

Qi Guan:

So that doesn't change.

Rob Almeida:

Yeah, I mean, the way I think about it is, we tend to think about debt in absolute terms, but it's really debt relative to income. And so on the corporate space, what I worry about is, we should be normalizing income, we should be normalizing margins, we should be normalizing cash flows, which we do. I mean, the market. What the market doesn't do is normalize leverage ratios for corporations. So what I'm driving at, it just seems like when you normalize for cash flows that there's seemingly less risk in your space today, given what you're describing.

Qi Guan:

So one of the things that I do want to point out when we talk about normalizing is that, if a new issuer comes to my market, I completely discount the strong performance that happened in last two years, because those are not normal times-

Rob Almeida:

Right.

Qi Guan:

And we are probably not going to see that ever again.

Rob Almeida:

Yeah.

Qi Guan:

And I will not take that performance data as an input to my analysis to project how many consumers are going to default, what the default rate is going to look like, how much loss they can occur. What I will do is actually go all the way back, looking at a particular issuer, or a particular company's historical loss curve, and their historical losses, and use that as an input to my analysis. And obviously, there might be plus or minus on each end, but I'm definitely more comfortable using that as an input, versus trying to normalize today.

Rob Almeida:

Right, Which is generally what Wall Street seems to do, they just take point in time over the-

Qi Guan:

Right.

Rob Almeida:

Last 12 months, so they do that with trailing 12-month EBITDA, or trailing 12-month-

Qi Guan:

Yeah, we go all the way back.

Rob Almeida:

Right. Right, right. You need to look at pre-stimulus, pre-COVID levels, and try to-

Qi Guan:

Right.

Rob Almeida:

Come up with a true normalized.

Qi Guan:

Right. We also look at if a company operates before the financial crisis, what happened during a financial crisis, and look at the quality of those loans compared to the quality of the loans today, and look at how much they actually... What the lost weight looks like back then-

Rob Almeida:

Yeah.

Qi Guan:

And kind of come up with own assumption or inputs to make a better projection on.

Rob Almeida:

That's an important point, so it's not just normalizing, but it's normalizing and then stressing it.

Qi Guan:

Right.

Rob Almeida:

Run it through the '08 model.

Qi Guan:

Yeah.

Phil Burgener:

But that is a great question, Rob, and we are seeing-

Qi Guan:

Yeah.

Phil Burgener:

Some very attractive opportunities in asset-backed right now. Going back to your corporate question, you're right, BBB investment-grade corporates, leverage ratios are still in line historically but elevated, but there are a lot of headwinds, and if you add in a recession, that there is, at least from our IG analyst's perspective and portfolio managers on the credit funds, there's real downgrade risk-

Rob Almeida:

Right.

Phil Burgener:

A lot of fall angel risk.

Rob Almeida:

Right.

Phil Burgener:

If I look at valuations in IG corporates and BBBs, and I compare them to, similar to Qi's, one of the recommendations on AAA or AA asset-backs backed by prime consumers, I can replicate the similar yield spread, and in a lot of cases actually, earn more spread than a BBB corporate. And I have a natural de-leveraging structure. As borrowers pay down their loans, as they pay down their principal, the structure de-leverages, I have no refinancing needs.

Rob Almeida:

Yeah.

Phil Burgener:

I am not beholden to what a corporate management team decides about when, or if they'll de-lever, or will they do share buybacks-

Rob Almeida:

Yeah. Or worse, [inaudible] lever up to buy a company.

Phil Burgener:

That's right, exactly. And this pointing in the cycle-

Rob Almeida:

Yeah.

Phil Burgener:

Those are real concerns. Now, why are ABS spreads as wide as they are? Our view is, and we've seen some headlines out there about concerns around the consumer.

Qi Guan:

Right.

Phil Burgener:

But this is when it pays to be active.

Rob Almeida:

Right.

Phil Burgener:

When you have the resources and the capabilities, as we do, to actually look at the loans, talk to the originators, understand the structures, and feel comfortable with those cash flows, we see this concern in the market as an opportunity to own really cheap, high quality cash flows at a time when I think there's a lot of uncertainty around monetary policy, when... If there's a recession, my view is, I'd much rather own the AAA, AA-rated asset-back backed by auto loans, hard assets, versus the AAA corporate right now.

Rob Almeida:

That makes sense. Well, listen, thank you both very, very much. I enjoyed this. If it's not too much to ask, I think given the, what seems to me increasing potential for recession in '23, we're going to have you back some point next year, hopefully earlier than later.

Phil Burgener:

We would love to be back.

Qi Guan:

Yeah, thank you for having us.

Phil Burgener:

Maybe not under a recession, but...

Qi Guan:

Hopefully there's no recession-

Phil Burgener:

[inaudible]

Qi Guan:

Or hopefully the recession's over-

Rob Almeida:

Right, there we go.

Qi Guan:

By the time we're back.

Rob Almeida:

There we go. All right, well, thank you both.

Phil Burgener:

Thanks, Rob.

Qi Guan:

Thank you.

Rob Almeida:

Thank you for listening to this edition of Strategist's Corner podcast. I'll be back in a few weeks with a final 2022 podcast with my good friend and our chief economist, Erik Weisman, and our thoughts ending the year, and a look ahead into 2023.