Fixed Income Meet the Team: Asset-Backed Securities with Jingwei Lei, CFA

Douglas Gimple (00:12):

Hello, my name is Douglas Gimple. I am the senior fixed income portfolio specialist here at Diamond Hill, and I'm here today with Jing. We le to discuss his role and his experience in the fixed income world and to give you a better understanding of who our team is. So Jing, we thank you for joining me today. So why don't we start with you giving a little bit of your background and what initially sparked your interest in this industry.

Jingwei Lei, CFA (00:39):

Thanks, Doug. I've been at Diamond Hill for a little bit over two and a half years, primarily the ABS analysts here. Generally the layman's definition of ABS is really anything that's not secured by a building. So you have residential and commercial. ABS is all the other collateral types essentially. So over time, broadly, that has meant subprime auto credit card receivables, equipment, but over market cycles you'll have more esoteric collateral types jump in. So right now, digital infrastructure is a big example. In the past we've had aircraft, et cetera. So it's really an interesting sector where issuers and collateral types cycle in and out. So my first internship out of college was actually at a fixed income shop in Los Angeles, and I got to work on a trading desk with PMs and traders. And for me it was just the excitement of synthesizing what I was learning in college at the time I was a finance major and then the excitement of engaging every day over markets, watching how news, for example, might impact the treasury curve or earnings announcements may impact a bond position that we own. It was very exciting and pertinent to what I was interested at the time, and I've just never shaken off at that passion, I guess. So after my internship, I spent some time at a consultant and then I joined a large tech company and over time I actually settled on a job. It's very similar to what I'm doing now except I was looking at much more higher quality ABS securities.

Douglas Gimple (02:30):

And so that's one of the things about the market that is really interesting. I would say over the last 10 years maybe or longer since the financial crisis, is how much the industry has expanded into those esoteric parts of the market to where they're now a pretty significant part of the issuance and the overall market.

Jingwei Lei, CFA (02:52):

And if you think about how the market has evolved over the last 10 years, that's a great point. If you look at how I think about the market where it's bifurcated, you have issuers like the Toyotas and JP Morgan Chases of the world that don't necessarily need to issue ABS, there's plenty of unsecured funding that we can get very cheaply. But for diversification, the fact that they can match liabilities very easily with their assets, they will issue at levels that are comparable to unsecured funding or maybe even slightly more expensive, but it makes sense for them to maintain that market access in case they do need it. We tend to focus on issuers that for whatever reason including lack of track record volatile underlying P & Ls exotic business models that have assets on their balance sheet that can produce durable cash flows. And if they securitize those assets we can actually get funding that are significantly cheaper than they can get otherwise unsecured. So over time you'll see consumer issuers come to the market you'll see aircraft digital infrastructure et cetera et cetera. So it really keeps the market exciting

Douglas Gimple (04:09):

With that exciting part of it. There are very nuanced parts of the market, things like, and I know you don't necessarily look at them as an investment, although that's possible. Things like music catalogs and auction securities and property assessed clean energy, all these different areas that have continued to grow is just a reflection of the market itself and how it's not just what we've talked about are credit cards and autos, which are kind of the standards that everyone knows about, but these other areas of the market that we may not invest in all the time, but that it's something interesting that we can look at.

Jingwei Lei, CFA (04:43):

Yeah, so the other dynamic is you've had issuer pushed growth in the market, but then there's also been a tremendous amount of growth in investor demand. So over the last 10 years you've had PE firms, you have private credit. So for example, in the music royalties, traditionally or historically, that's not been a collateral that people would think is a great candidate for securitization, but you have PE firms that have come in and brought up these catalogs that want to lever up. So ABS for music royalties is a way to do that, and you wouldn't have seen it without the investor appetite for those securities.

Douglas Gimple (05:24):

So let's take a step back and can you walk us through your typical research process for evaluating what could be a potential investment ?

Jingwei Lei CFA ( 05 : 34 ):

Sure, sure. It's not rocket science. So generally what we look at first and foremost is the collateral values being securitized and its ability to generate sustainable predictable cash flows. And our gauge for that is most of the time it's going to be historical performance. So if comes in and tries to raise financing off of a pool of auto loans and they're telling us that they have a new angle on underwriting subprime for example we're going to want to see the track record through multiple market cycles to see how that collateral will perform how volatile are your delinquencies your losses your prepayments and from that we can assess the amount of structure that we need or the amount of spread that we need to get paid to take on that risk away from more down the middle collateral types like auto like credit cards for more esoteric things generally you have less of a track record so that generally means you want more securitization. So if things go wrong you have subordination you have excess spread you have reserve accounts to protect you and then also you want to get paid for risk. So that just means fatter coupons in general.

Douglas Gimple (06:59):

One of the things about ABS that allows us to diversify and look at not just investment grade, but when you're looking at below investment grade, maybe talk a little bit about the capital structure just from a high level about T tranching and how, if you like a deal, you could buy the A or the B tranche in one strategy, but then you could buy the D and the E tranche in another strategy because that strategy can take on more risk.

Jingwei Lei, CFA (07:24):

Sure, sure. So what's special about securitization is compared to all the other fixed income sectors, you can target risk a lot more precisely. If you're talking about sovereign risk, it's one risk. If you're talking about corporate risk, generally it's one risk. You have some differentiation in the capital structure. But when you're talking about securitized risk, it's deal by deal. And then we've been deals, it's t tranched by tranche, right? So if you have a typical ABS issuer has 20 deals outstanding, and each deal has four tranches, that's ED types of risk that you can evaluate and pick and choose. So it really gives you a lot of power to dial up and down depending on your risk tolerance and then also your return objectives. But the way it works is a typical deal will come to market with anything between three to six tranches.

On average, the senior tranches are the biggest, and those are generally rated between a AAA to a single A, and those generally are very hard to break. What I mean by that is you can stress the cash flows very severely. You can have very severe macroeconomic assumptions, but those will be robust. So typically we refer to 'em as more safe positions. As you go down the stack, securities will become more sensitive to the volatility of cash flows, the volatility of a macro environment all the way down to the most junior tranches, the subs, or sometimes even the residuals. And for those securities, you really have to be comfortable with the risk that you're taking on, recognize that even normal variations in cash flows may impair those securities. So what you really want to do is you want to make sure that you're getting paid to take that risk. And typically for a below IG ABS security, we will see anywhere between 400 to a thousand spread. So it's a fat coupon to cushion you for any shortfalls that may occur down the road.

Douglas Gimple (09:45):

And so how does the role of the issuer play into your analysis? And you mentioned like a JP Morgan or a Toyota, very well known, you've got a pretty good handle on them. But when these newer issues come to the market or issuers that have been around for maybe a couple of years, how important is it to get to know them and understand how they think about risk?

Jingwei Lei, CFA (10:07):

Sure, sure. So you have to assess the role of the issuer in maintaining that collateral to make sure it performs. So I'll take auto for example, that is perhaps less important because if an auto doesn't perform, you can always go and repo a vehicle. And then also the performance of a lender once they issue a loan, doesn't really have a big impact on whether the underlying borrower decides to pay a car note or not. But there's other sectors where it is very important. So for example, digital infrastructure for data centers, for fiber optic networks, you really need to have high confidence in the issuer because they’re the ones maintaining the buildings, they’re the ones growing the network. So if they go out of business, the ability of, for example, the underlying fiber network to generate the requisite cash flows to pay off in notes is severely impaired.

Douglas Gimple (11:05):

So one of the things, so we've talked a little bit about digging into the details and understanding the issuer and the underlying collateral. What about macroeconomic factors and market trends? How does that factor into when you're looking at consumer unsecured, there's been a lot of talk about how the consumer is impacted by the macroeconomic environment and their ability to pay back, whether it's consumer, unsecured or credit card or autos.

Jingwei Lei, CFA (11:31):

Sure, sure. So if you look at primarily consumer risk, obviously it is impacted by things like unemployment rate inflation. So most things you have to keep a handle on, but I would say that's only half of your equation. The other half is the underwriting and the structure like we talked about. So you can have a historically low unemployment rate, but if you are still sloppy and underwriting, the deals can still perform pretty badly or worse on expectations. And we actually kind of saw that on a tail end of COVID when money was free and everyone was getting a loan, and even though the unemployment rate was sub 4%, but 22 and 23 vintages, a lot of them did underperform and some of them ended up taking principal losses.

Douglas Gimple (12:21):

And that leads me right into the underwriting standards and how they can tighten and loosen. And you mentioned in 2021 and 22 different vintages, in other words, the years that are issued, you can kind of see that trend as time goes on, as to whether or not underwriting standards loosened or tightened. Is that something that you can see? And if so, how do you analyze that on a monthly basis?

Jingwei Lei, CFA (12:44):

Sure, sure. I mean, it's tricky. It's easy to say, but it's hard to enact. And I'm going to say something very obvious here. You get paid on the perceived risk issuers raise money on the perceived risk. So to go back to the COVID example, when money was free, interest rates were zero, and unemployment was very low, everyone's perceived risk was also negligible. So that's why insurers are able to loosen their underwriting considerably. The spreads, the coupons were effectively zero. So you weren't getting paid to take the risk, but that was kind of a market sentiment, and it takes a lot of discipline to not go over herd, but that's what you want to do. So in hindsight, obviously if you bought those vintages, you had a really rough experience. But the flip side is when people were panicking on the realized performance, subsequently, if you held your nerve and bought those vintages where the coupons were fat to compensate for the risk that people were regretting taking the year prior when the underwriting was getting tightened up considerably as a reaction to the year prior loose underwriting, you can actually generate a lot of excess returns for clients.

Douglas Gimple (14:11):

Thus, the importance of understanding what you own when you're looking at this part of the market. So one of the things that I've talked about a bit in meetings that I've had are remittance reports and the benefit of those where on corporate debt, you get earnings announcements that everybody gets to listen to, but with remittance reports, walk me through those and the kind of insights you can get from them.

Jingwei Lei, CFA (14:35):

Sure, sure. So if you invest in a typical corporate, you have quarterly earnings announcements where the earnings announcements impacts everything, right? All up and down the capital structure from equity to the debt, et cetera. It's a little bit different for ABS, because for each deal, you'll have a monthly remittance report, right? So an issuer with 20 securitizations outstanding will publish 20 remittance reports monthly. So you can imagine how that adds up over time. For us, it's incredibly important to stay on top of those for all of the securities that we own. So it takes a lot of experience to A, know what you're looking for, B, go through everything efficiently and then see how to react when you see something that may or may not be material. So generally what we do is every month we will go through the remittance reports one by one.

We have a program called intax that kind of consolidates everything for us, but we still take care to take a look at each and every number. That's important for all the deals that we own. If things don't look on trend, generally we will go back to historical numbers to see whether that may arouse concern or not. So sometimes, for example, in subprime, you have a lot of seasonality. So when the holidays roll around delinquencies and losses on the rise, people are more focused on buying Christmas presents, for example, if things do look off, we will often contact the issuer to try to get more color. So oftentimes the issuer may have a perfectly good or believable story to tell. Oftentimes they may not. And at that point, you need to make a decision on whether you want to continue to hold the security or you want to exit at a good level.

Douglas Gimple (16:47):

So my last question for you is more kind of team oriented that how do you interact with the other members of the team, whether it's Wenting on the CMBS side, or it's Arthur on the high yield side, or Dane and Mark on the investment grade corporate side?

Jingwei Lei, CFA (17:02):

The team is very small, so communication is super responsive. It's a flat structure. So for example, with Wenting, it's important, I understand the crossover issuance between ABS and CMBS, especially in data center. There are a lot of issuers that cross between the two sectors. It's important to understand what their motivations are and then the relative value that we can generate allocating between the two sectors. On the credit side, especially with Arthur, there's also a lot of high yield issuers that may issue an ABS with cheaper cost of funding. So he can provide really good insight into those issuers, their motivations. The unsecured credit profile that I find very useful as well. And also for some of the more credit sensitive strategies, we do allocate between high yield and mostly sub investment grade ABS as well. And same thing on the credit side too. It's great to have insight on, for example, the auto sector when we're looking at subprime issuance.

Douglas Gimple (18:09):

Jing, we thanks so much for joining me today. I really appreciate it, and your insights into your responsibilities and some of the nuances within the ABS market.

Jingwei Lei, CFA (18:16):

Oh, pleasure to be here, Doug. Thank you so much.