The Untapped Power of ABS in a Modern Portfolio with Andrew Hsu

Well, I came out of college as a consultant. I was working in litigation finance, which was really the valuation side of lawsuits. But I always found myself more interested in principling risks, still on the investment side. So I did find myself working with Jeffrey Gunlock at our previous firm in 2002, and then DoubleLine really formed in the end of 2009.

So I was a part of the, I guess, the founding members that came over from DoubleLine and the rest has been history, but it's been a really exciting ride.

[00:00:55] Doug Heikkinen: Yeah, I watched that video yesterday on your website of how it all started and how you got things together so quickly and it was just a, it's just a fascinating story.

[00:01:04] Andrew Hsu: Yeah, no, it was, and, I wish I would, I could say it was just good times the whole time through. It was definitely some scary times, but that makes it exciting.

[00:01:14] Doug Heikkinen: That's for sure. So let's get into why we're here. DoubleLine recently launched an ABS ETF, ticker symbol DABS.

Can you give us an overview and explain what motivated DoubleLine to introduce this product to the market?

[00:01:28] Andrew Hsu: Sure. We've been investing in asset-backed securities for well over a decade. And years ago it was mainly an institutional client kind of focus. And they found asset backed very appealing for many reasons.

The three traits that really seemed to be the big drivers were, asset backs, they demonstrated lower correlation to other areas of fixed income. So that definitely was beneficial. They had very low default rates, and tended to be quite resilient, even in the most stressful economic environments.

And then finally, everyone was always searching for yield. And asset-backed securities, they do offer a yield premium to other areas of fixed income. So that was very interesting for investors. Now, the sector, it's performed quite well over the years and it's really grown significantly.

And this is both in terms of the depth of investors involved in the space, but also the breadth of industries that are covered by the space now. It was in-demand tool for institutions and we did feel that it could be a useful tool for a broader investor audience. So we introduced DABS as the first ABS, or public ABS dedicated ETF, to a broader audience.

[00:02:40] Doug Heikkinen: So how does DABS differentiate itself from other fixed income ETFs?

[00:02:45] Andrew Hsu: Not everyone knows that asset backed securities, they're actually a component of the AG, aggregate bond index, already. So anyone who's invested in AG Index has a tiny exposure to ABS. But if you wanted to dial it up, it was largely inaccessible to the broader investor community. There are other ETFs available out there that have ABS in their mix, but often they'll be combined with other types of fixed income. So it could be mortgages or CLOs or even corporates. DABS is the first 100% focused ABS ETF out there.

First to be introduced, I should say. And it's fair to say that we're quite differentiated just on that alone, versus other fixed income ETFs.

[00:03:28] Doug Heikkinen: For our listeners who may not know what an asset-backed security is or ABS, can you explain to our audience what it really is?

[00:03:36] Andrew Hsu: Yeah. It's actually quite simple.

An asset-backed security, it's a credit fixed income investment. And this is where an investor is actually directly secured by an asset or a pool of assets and any of the cash flows associated with those assets. So if you think of yourselves as an ABS investor, what you'll have is a defined asset pool, and then all the cash flows, and it's quite transparent, are essentially dedicated to you as an investor.

[00:04:05] Doug Heikkinen: Is there a distinction between mortgage-backed securities, CLOs, commercial mortgage-backed securities, and ABSs?

[00:04:13] Andrew Hsu: Yeah, so, sometimes they're all categorized together. But I would say within the industry there is definitely a difference. Mortgage-backed securities are specifically secured by residential home loans and the homes themselves.

Commercial mortgage backed securities are secured by commercial real estate and any cash flows that are essentially flowing into those commercial properties. And CLOs, closer cousin to corporate kind of exposure, they're secured by a pool of corporate loans or bank loans, as everyone calls it. Now, ABS specifically, they are secured by assets across many industries.

And the pools of collateral can be consumer in nature or backed by revenue generating hard assets. And, we call these commercial ABS and the distinction is ABS is non-mortgage related risk. So it could be everything from consumers to, like a power plant, but really excluding mortgage exposure.

[00:05:11] Doug Heikkinen: Maybe, it would be helpful if you gave an example of each, a consumer ABS, and a commercial ABS.

[00:05:19] Andrew Hsu: Yeah, absolutely. So we'll start with the consumer ABS. That could be a transaction backed by personal loans or credit cards or student loans, and I think everyone would probably understand that. So essentially you would take a pool of these loans and essentially create a security out of them.

And any of the cash flow that is essentially flowing into these assets would flow to the investor. Alternatively, the commercial asset back side, which is really securitizing hard assets, these transactions could be secured by renewable energy, so it could be solar, solar fields, wind energy, even traditional oil and gas.

And then your collateral would be the actual asset and any cash flow that's generated by the service that asset provides. So that's really a commercial ABS exposure.

[00:06:10] Doug Heikkinen: When comparing ABS's and corporates of similar ratings, why is it that there's a yield premium to ABS securities?

[00:06:20] Andrew Hsu: Yeah, we get that question a lot. I think there are three reasons for that. First it's just due to their, and I'm gonna put it air quotes here, perceived complexity. A lot of people believe that these are really complex instruments, and I think if I could spend just a few minutes with them I could dispel that notion. Also secondly, the buyer base is much broader for corporates than it is for ABS or at least historically it has been. So that will naturally drive some pricing efficiencies on the corporate side, and thus you might see wider spreads or yields on ABS.

And then finally, mechanically there is one difference. I shouldn't say one. There are many differences, but the main one I would say is that corporates, you're technically, you have cash flows generated by the entire corporation available to service your debt. Now, investment corporates, they're unsecured by nature.

ABS is a bit different. ABS, you're secured by the actual asset, but you do have a predefined pool of assets and any cash flows that are flowing into those assets that would essentially service your debt. So you don't, you're not available to have essentially the entire corporation cash flows to service your debt. You're really kind of focused on this pool of collateral. And that's, I would say that mechanically, that's what's different versus corporates from, asset-backed securities. and I think all three of those reasons do drive some of the yield premium that you see in ABS.

[00:07:44] Doug Heikkinen: Yeah. Let's get a little more into DABS. So DABS aims to seek long-term total return while striving to generate current income. Tell me a little bit about the fund's investment approach.

[00:07:56] Andrew Hsu: The team, we're focused on maintaining a portfolio where risk is mitigated through diversification. And because ABS is so diverse, we can invest in a number of different industries.

And what we really are hoping for is that the economics for this vehicle are generated through both cash flows and capital appreciation. We're not really looking at one or another. We're really looking for both. Spread compression, if we're only looking for spread compression, that becomes a little bit more challenging because spreads do ebb and flow.

Or if we're only looking for the securities with the highest yield, certainly we've seen investors do that. You can get yourself into some pretty deep trouble by doing that. So the focus is really building a portfolio that maximizes the risk adjusted to return through to the investor, really through both capital appreciation and through regular stable cash flows.

[00:08:48] Doug Heikkinen: How is an offering like this additive to an investor's portfolio?

[00:08:53] Andrew Hsu: I think for three reasons. I mean, diversification one, enhanced yield is the second one, and downside protection is really the third. And I'll expand on all three of those just real briefly here. So we looked at historical, and this is a 10 year study of correlations of various fixed income sectors.

And this is structured products, corporates, treasuries, so all of the above, and we compared it versus the aggregate bond index and ABS had the lowest correlation of any fixed rate product. So it is fair to say that adding ABS to an existing portfolio would have some diversification benefits, especially since, prior to the launch of DABS, it's been extremely difficult for the broader audience to get access to asset-backed securities.

Now, the yield also is a big, kind of, attractive variable here too. Yields tended to be at least a hundred basis points higher than similarly rated corporates over that same 10 year period. So there certainly has been a yield advantage. And then finally, in terms of just downside protection, rating agencies, they did this analysis going back to the year 2000.

So it's quite some time. And they looked at default rates across different asset sectors and ABS securities, especially the investment grade portion, they had close to zero defaults going all the way back 25 years. So if you can get diversification, you can get yield and at the same time, it can withstand some pretty difficult economic environments, it does seem like it's additive to investor portfolios.

[00:10:25] Doug Heikkinen: Let's get a little under the hood here. The ETF focuses on investment grade asset backed securities backed by a diverse set of assets. Can you discuss the types of underlying assets that are included and how they contribute to the fund's performance?

[00:10:40] Andrew Hsu: Yeah, absolutely. I would want to clarify, the fund can invest up to 20% in below investment grade assets, but currently we have 0% allocated there. So everything is investment grade right now. The ETF, it's diversified. It has more than, 15 different industries that investors can be exposed to.

All the investments are secured, so there's an actual asset or pool of assets behind them, and then they're all cash flowing, so they're both receiving regular interest and principal payments. So, there's definitely a focus on regular cash flows. We do tend to focus on consumer related assets for their wide spreads and relatively short duration.

If you think about a typical consumer loan, it's not extremely long in tenor. Usually it's one to three year type kind of duration. So we do like the consumer loans for the shorter duration aspect, and they also have wide spread. These can generate a substantial amount of cash flow on a monthly basis, which we use to either pay dividends or to reinvest in new opportunities.

Now, the hard assets or the commercial assets, they're going to be a bit longer. So if you think about a hard asset, typically the useful life is going to be longer than say a short consumer loan. So these are typically between five to seven years long. They also generate cash flow, but they also add a quite a bit of like excess return if spreads tighten.

So we do see the hard asset side as a resilient sector that can offer alpha in the form of capital appreciation in addition to the cash flow. So this is how we kind of use the two components, consumer side for high cash flow and then the commercial side for more of the spread appreciation benefits. The fund currently it's single A rated, has a yield of 6% and only a 2.1 year duration, so we're quite short positioned at this point in time.

[00:12:33] Doug Heikkinen: How does DABS manage credit risk while seeking the attractive returns?

[00:12:39] Andrew Hsu: Yeah, risk management. It's done at a couple different levels. At the portfolio level it's done through diversification. As I mentioned, we do have exposure across a number of different industries, and this is really an effort to diversify away idiosyncratic risk of a single industry. So, having that diversification certainly helps us, quote unquote hedge risks out from one sector to the next.

At the security level, we're also very focused on two things, the collateral and then the structure. If you have strong collateral with stable cash flows, that's extremely helpful. But having a structure that can withstand severe economic conditions, I would call that the insurance policy, if you will.

So if your collateral for some reason fails and defaults are much higher than you expect, the structure can essentially save the investment and we're focused on both having strong collateral and then very durable structures that can withstand a lot of stress. We do run a wide range of scenarios on each of the positions that we invest in.

So we'll run a bull case, a bear case, extremely difficult bear case to see if they can withstand these stresses. And that's how we're selecting assets into this portfolio.

[00:13:51] Doug Heikkinen: Are there liquidity challenges in this space?

[00:13:55] Andrew Hsu: Historically there have been some bouts where there have been liquidity issues.

And I would say, when I say historically, I'm going all the way back to the financial crisis in 2008. And since then, I would say a couple things have developed, is the market has grown significantly, and then the investor base has grown quite significantly as well. So from a liquidity standpoint, even using covid, which is probably the most recent big disruption in the market, we didn't have issues obtaining liquidity in this market. So I would say liquidity is far improved in this space. But historically, you've seen some hiccups, but it seems like that may be in our past, given how many investors are in this space now.

[00:14:35] Doug Heikkinen: For financial advisors, where does DABS fit within the well diversified portfolio?

Is it more suited to a core holding or a satellite allocation?

[00:14:46] Andrew Hsu: Yeah, that's a good question and that's definitely a question that a lot of wealth advisors have asked us. We do see this as a core staple for active managers. As I mentioned, the ABS as a component is already in the AG.

It's just you had no way to access it in the past. For our own core funds, there is a dedicated allocation to ABS, and we do envision or we would envision that investors could get value by using DABS in a very similar way by dialing it up or down, depending on where they view relative value of ABS versus other options in fixed income.

[00:15:23] Doug Heikkinen: So given the current economic landscape, including interest rate fluctuations and consumer credit trends, how does DABS position itself to navigate these factors?

[00:15:34] Andrew Hsu: DABS is actually a managed fund, so investors should expect the asset mix to change over time. Currently, and everyone's going to have their view on the economy, our view is that the economy is certainly slowing. You can see it in the metrics. So there is a heavier focus on commercial or hard assets at this point in time. And investors or anyone who's interested can think of these as more infrastructure type exposures, where slowdowns in the economy tend to have less impact on the economics of these investments and the utilization rate stays relatively high. So at this point, 70% of the fund is allocated here. The balance or about 30% of the fund is in consumer assets. And listeners may be scratching their heads and saying, Hey, Andrew, you just said you know, the economy's slowing down, then we're going to contraction.

Consumers may face difficulties here, and we certainly would agree with that notion. But, here's where I would say consumer investments with strong structures, and that's certainly what we're looking for, can withstand greater than GFC type stress and not see principle loss. So if we can invest in those types of consumer type plays, those are what we're interested in and 30% of the portfolio is concentrated in that area.

[00:16:49] Doug Heikkinen: You mentioned DABS is actively managed. Discuss the advantage of active management in the asset backed security space and how it benefits investors.

[00:17:00] Andrew Hsu: Yeah. Active management, it's important. I would say, opportunities and risks that are going to vary, depending on where we are in an economic cycle.

And currently we see the United States in contraction stage. So we have an overweight towards commercial assets, given just the inelasticity of their demand and their stable cash flows. In a recovery phase, the consumer health will be improving. typically spreads are gonna be very wide there.

And we see that as a very good time to overweight consumer transactions. So, you should expect, or investors should expect this portfolio to change in composition depending on where we are in the economic cycle. Active management to us for all of our vehicles is very important. It can help reduce risk through cycles, but also it can help drive alpha.

And that's really what we're aiming to do is deliver the best risk adjusted return to our investors.

[00:17:52] Doug Heikkinen: So last one for you. Looking ahead, what trends or developments in the asset-backed securities market do you anticipate and what kind of opportunities do you see in this space?

[00:18:04] Andrew Hsu: Yeah, I see quite a few.

So, first I would just say on the kind of the sector side, I would see more issuance volume in this space. I certainly expect that this year and in the years ahead, and from new industries. So I think new industries will tap the ABS technology as it becomes more widely utilized and more widely accepted.

We've seen already a number of corporate crossover issuers finance in the ABS space. So that is potentially kind of substantiating our thesis that new industries will enter this space. I also see more investors coming in. Insurance companies and pensions, they've been huge adopters of this asset class.

And my hope is that the retail and wealth channels, they follow suit because there is meaningful benefit by adding this asset to your portfolio. Institutions have, and now is a chance for wealth advisors and even individuals to consider adding this exposure into their portfolios.

From an industry standpoint, there are a few kind of thematics that we see as pretty big growth areas. Everyone's talking about AI. And to do that you need different types of infrastructure in the telecom space. So data centers and other type of telecom assets are starting to become financed through the ABS channels.

And also energy investments. Oil and gas is having some issues in terms of just commodity prices right now. But overall, capex spending is expected to need to grow in this space. And I do think that ABS will be a issuance channel for a lot of these operators out there who are looking to grow their platforms. And then later in the cycle, there may be some hiccups within the consumer space. And honestly, we would welcome that because we do think that would be a great opportunity for DABS and our investors to get some additional exposure to this space. The consumer drives 70% of the US economy. So it's extremely important component here, and there are very few ways to directly access that channel.

We see DABS as one way to do that. Really exciting time in the markets, I would say overall. And the teams really kind of focus on, delivering some interesting opportunities via DABS. And I will say this, just shameless plug real quick. For any investors who might be interested listening to this podcast and want more information, we do have a DABS webcast coming up later in June. So if anyone's interested there please go to doubleline.com and you can sign up for that event. And we will be talking about some of our latest opportunities that we're investing into during that webcast.

[00:20:41] Doug Heikkinen: Andrew, you've been there since the beginning. Your passion is evident, so thank you so much for joining us.

[00:20:49] Andrew Hsu: Thanks so much for having me and I hope we speak again soon.

[00:20:52] Doug Heikkinen: To learn more about DoubleLine, please visit DoubleLine.com. We are on all social media platforms @Advisorpedia. Please give us a follow. For our producer Tory Miller and the Power Your Advice Podcast team, this is Doug Heikkinen. Thank you for listening.