Canceled student loans can be a bonanza for bonds

(Bloomberg) – The cancellation of student loans in the United States that progressives in Congress are calling may not be a bad thing for investors in debt-backed bonds, because the owners of these securities are receiving sufficient returns high to offset any prepayment of principal. this may result.

Loan-backed securities issued under a now defunct program called the Federal Family Education Loan Program, or FFELP, will likely outperform other floating rate debt, although the Loan cancellation leads to a dreaded increase in prepayments. The industry would be inundated with liquidity as federally guaranteed bad credit loans are repaid and distressed borrowers avoid default, market participants said.

“If the Biden administration implements a certain level of debt forgiveness – $ 10,000 or $ 50,000 – it can lead to prepayment risk, shortening obligations,” said Darrell Wheeler, chief strategy officer. securitization at Cantor Fitzgerald LP, in an interview. “But even in our shortest prepayment scenario, bonds still offer an attractive spread recovery,” according to a recent analysis from the bank.

Like mortgage-backed securities mortgages, investors generally don’t like students to prepay their loans because this shortens the life of the bond and prevents them from receiving interest for a period of time. extended period. If the government pays off student loans, it would essentially be a big prepayment.

The impact of any discount usually varies and depends somewhat on the price paid for the bond. While canceling the loan would prepay the bonds and reduce the average maturity, it should only have a minor impact on expected spreads, depending on the price paid for the bond, according to Cantor’s analysis. .

The government guarantee on FFELP student loan bonds makes these instruments an attractive product to consider when rates rise, especially in an uncertain macroeconomic future, Cantor said. Other variable rate fixed income products such as back-to-back loan bonds, for example, do not have such a guarantee.

“Loan forgiveness could be a boon to student loan ABS by providing prepayments and cash immediately after forgiveness,” wrote Joseph Cioffi, partner at Davis & Gilbert LLP, in a blog post Thursday. “Whether the loans are federal or private, the lender would be paid off and prepayment rates would rise, but at least distressed borrowers would be less likely to default.”

Until July 2010, the FFELP program financed the majority of the costs of post-secondary studies. Private institutions would arrange loans with nonprofit or state entities acting as guarantor, and the Ministry of Education would essentially support or reinsure the guarantor. Large loans were taken out before the program ended and more than $ 250 billion of them remain unpaid today, Cantor said, and they are still bundled into new asset-backed securities.

The new stimulus plan leaves the door open to a possible reduction in student debt. Members of Congress would like President Biden to enact some degree of pardon by executive order, but he has indicated he prefers to do so through congressional legislation.

Synchronization problem

Although there is very little credit risk in FFELP ABS, there is enormous uncertainty about the timing of repayments which can be problematic.

Loan cancellation would shorten the potential term of the bonds, while deferrals, forbearance, and so-called income-based repayment programs delay repayment, leading to an extension risk that can delay debt repayments in the future. beyond their final deadline. This could mean that senior installments are not paid on time, if at all. This aspect led many rating companies to downgrade student loan ABS last year.

Like other asset-backed sectors, FFELP student loan bond spreads widened at the start of the pandemic, but recovered over the summer and have since compressed at a sustained rate, particularly when investors realized it was a maturity risk issue, not credit. risk one, said Wheeler.

He believes that FFELP student loan abs have recession-resistant value. Investors can get a variable rate spread guaranteed by the Education Department during a period when rates may rise, he said. On the other hand, if we get through Covid stimulus spending and there is a recession, those bonds are still guaranteed by the government.

“If I wanted to find a government guaranteed, variable rate product with a 50 basis point to 70 basis point spread, the FFELP student loan ABS would be this one,” Wheeler said.

Relative value: CMBS

  • Deutsche Bank AG analysts like AAAs and junior AAs at current spread levels in CMBS conduit transactions, according to research note on Thursday
  • Single A CMBS tranches look fully valued, while BBB bonds look rich given the uncertainty of Covid losses, analysts said

Quotable

“Modest economic growth and an inflationary environment should support outperformance in the hotel segment, while returns from commercial properties will likely lag behind,” said Harris Trifon, portfolio manager and managing director of Lord Abbet. “Hotel owners can typically reset the price of their leases (eg room rates) on a daily basis, exhibiting a high correlation coefficient with inflation. Additionally, travel demand has fallen well below what we would expect to see in a normal recession due to travel restrictions and Covid-related lockdowns. We see the potential for increased demand as early as the second quarter of next year, which will help put upward pressure on room rates. ”

And after

ABS deals pending for next week include Pretium Partners (single-family rental) and Foundation Finance (home improvement loans).

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