WHO SAID FIXED INCOME INVESTING WAS EASY

By Peter Higgins
Head of Fixed Income and Senior Portfolio Manager

A Sudden Default Is Shining Light on Some Not-So-Visible Difficulties in the Credit Markets 

Pools of auto loans, aircraft leases, credit card receivables, or business loans can be packaged into asset-backed securities, representing contractual obligations to pay interest and repay principal to investors. The implied promise is if things go awry, then the underlying assets act as collateral. Active management is key to avoiding these pitfalls.  Fundamental credit analysis and continuous re-underwriting of credit investments cannot be overlooked at this point in the credit cycle when it’s become a bit too long in the tooth.   

And in many cases, auto loans are creditworthy because cars retain their value and can be easily repossessed and sold upon default.

That was until September when news broke that Tricolor, a Dallas-based chain of used-auto dealers, which essentially made its money as a sub-prime lender, shocked some of the industry’s largest lenders with a Chapter 7 liquidation. 

In hindsight, Tricolor’s business strategy of lending to borrowers with weak or limited credit history and unclear verifiable sources of income may have been a precursor to failure.  Reports suggested that many borrowers lacked traditional credit profiles, raising broader questions about the quality of the underlying loans.

Yet, by all appearances, Wall Street couldn’t get enough of the Tricolor debt. Several well-known institutional asset managers allocated investor assets to these instruments during the period. Some later characterized the outcome as ‘less than optimal.’ One bank executive admitted that the deal was, “Not our finest moment.”

NOT ON OUR WATCH

While the sudden bankruptcy of Tricolor’s more than $2 billion of high-risk subprime auto loans into public asset-backed securities isn’t even a rounding for the ~$900bn ABS market, it’s enough to give even the most experienced bond investor pause. The bankruptcy of Tricolor, along with potential losses at banks and investment funds, ought to be raising concerns about hidden risks in other parts of the fixed income markets.    

However, many of these loans were pledged to multiple securitizations, and the underlying cars that served as collateral would have competing liens on them on account of the malfeasance. 

The question to be asked now is whether there are more Tricolors out there in danger of going bad. Doubtlessly some, but this can be seen as a falter in due diligence, since it appears that there wasn’t a deep enough look under the hood of Tricolor’s $2 billion in ABS. Reverberations are being discussed across other fixed income products as well, especially the credit markets.  News has already spread to the private credit and the broadly syndicated loan markets. 

It is critical that fixed income portfolios be managed with both top-down and bottom-up research to support a disciplined underwriting approach. In markets like the current one, maintaining a focus on quality and understanding the unique dynamics of each issuer helps protect capital while identifying opportunities.