Asset-Based Finance: Scaling the Opportunity Set - FEDERATED HERMES INC

Financial Performance:

• Public Asset-Backed Securities (ABS) are currently trading at deep discounts with high single-digit yields for investment-grade solar and fiber bonds, offering attractive relative value compared to historical norms.
• The market has seen a shift from private credit dominance to public ABS as yields have converged, making public securitized credit a viable alternative with similar risk-adjusted returns but better liquidity.
• Trade finance and non-securitized asset-based finance offer defensive income with relatively low volatility, utilizing short-duration, amortizing loan portfolios with weighted average lives of roughly two years.
• Stress testing reveals that specific asset classes like solar and fiber can withstand extreme scenarios (e.g., no solar revenue) and mature at par, indicating strong fundamental resilience.

Guidance and Future Outlook:

• Institutional allocators are expected to increasingly view public ABS as a complement to private credit to diversify returns without sacrificing yield or rating, moving away from the previous 5-year bias toward private markets.
• Long-term growth is anticipated in digital infrastructure (fiber-to-the-home, solar), energy transition assets, and emerging market trade finance, driven by global capital flows and specific funding needs.
• The "private credit bubble" in sectors like data centers is expected to correct as issuance volumes become obscene and competition drives down relative value, creating opportunities for more selective investing.
• Future success will depend on manager selection and the ability to navigate the convergence of public and private capital markets as regulatory and market dynamics shift.

Business Segments and Product Lines:

• Solar: Identified as a high-opportunity sector post-subsidy removal and industry consolidation, offering deeply discounted investment-grade bonds with strong stress-test resilience.
• Fiber Optics: Focus is specifically on "fiber-to-the-home" or HOA-backed contracts which offer high stickiness due to inability to easily cancel, supporting stable cash flows.
• Data Centers: Currently avoided due to over-issuance and a perception that these deals function more like corporate leverage than true asset-backed securities.
• Trade Finance: A distinct segment of bank-originated, non-securitized loans financing tangible goods flows and commodity extraction, primarily in emerging markets.
• Aircraft & Containers: Traditional asset classes that remain volatile; investment is highly structure-dependent, with a preference for buying only when priced deeply discounted (e.g., 50 cents on the dollar) rather than at par.

Market and Competitive Landscape:

• Private vs. Public: A clear shift is occurring where public ABS is no longer a secondary option but a primary vehicle for relative value, offering liquidity and transparency that private credit lacks.
• Bank Constraints: Banks are retreating from certain lending due to regulatory capital constraints, creating a gap for non-bank providers (like Federated Hermes) to step in alongside banks without disintermediating them.
• Competition: Intense competition in private credit and data centers has inflated valuations, pushing investors toward "esoteric" or non-traditional ABS sectors like solar and specific fiber deals.
• Market Trends: Secular trends in digital infrastructure, LNG, and emerging market trade are driving capital flows, but investors must carefully distinguish between different financing structures (securitized vs. non-securitized) for the same underlying assets.

Risks and Challenges:

• Liquidity Risk: Liquidity in non-traditional ABS can evaporate during systemic stress (e.g., COVID-19), transitioning from plentiful on normal days to zero during crises, though less volatile than high yield.
• Structural Nuance: Not all "Triple-B" ratings are equal; structural weaknesses in certain asset classes (e.g., aircraft) can lead to significant losses during volatility, necessitating deep due diligence.
• Mark-to-Market Discrepancies: A significant risk lies in the mispricing of private credit assets which are often marked at par despite similar public CLO assets marking down to 80 cents, suggesting potential hidden losses in private portfolios.
• Interest Rate Sensitivity: Higher-for-longer rates pose risks to consumer-facing asset classes (e.g., subprime credit cards, consumer receivables) where increased fuel or living costs could impact repayment ability.
• Concentration Risk: Over-concentration in specific sectors like data centers and corporate-style ABS could lead to systemic issues if those specific markets correct.

Management Commentary and Tone:

• Tone: Both panelists (Paul Norris and Martin Offeringa) expressed a cautious but opportunistic tone, emphasizing the importance of "know your manager" and rigorous underwriting over chasing yields in crowded sectors.
• Confidence: High confidence in the fundamental resilience of specific sectors like fiber-to-the-home and solar, provided the bonds are purchased at appropriate discounts.
• Philosophy: Management advocates for a "barbell" approach, utilizing both public and private markets to optimize risk-based capital and relative value, rejecting the notion that one is inherently superior to the other.
• Due Diligence: Emphasis on "stress testing" portfolios against worst-case historical scenarios (GFC, COVID, Ukraine) and understanding the specific mechanics of every underlying asset.

Analyst Questions and Answers:

• Q: How does ABS perform in a higher-for-longer rate environment?
  • A: Generally stable for commercial assets (containers, rail) but risky for consumer-based ABS (subprime cards, receivables) where economic pressure could lead to defaults.
• Q: What does trade finance offer that direct lending does not?
  • A: Trade finance provides non-overlapping, transaction-specific exposure to tangible goods flows and emerging markets, unlike direct lending which focuses on general corporate balance sheet leverage.
• Q: How should investors evaluate managers and monitor portfolios?
  • A: Investors must "kick the tires" on risk management systems and stress testing protocols. Monitoring non-securitized loans involves name-by-name review based on mandatory borrower disclosures.
• Q: How to compare risks beyond reported marks?
  • A: Use CLO collateral valuations as a benchmark to identify "mispricing" in private credit funds that are marked at par while public equivalents are marked down significantly.

Other Key Points:

• Regulatory Arbitrage: The recent explosion in asset-based finance growth was partly driven by large insurers leveraging regulatory arbitrage to access private opportunities with attractive risk-based capital treatment.
• Underwriting Methodology: Federated Hermes employs a fundamental, bottom-up underwriting approach for individual transactions (requiring full recourse, guarantees, and asset pledges), contrasting with programmatic, index-driven approaches.
• CLOs as a Barometer: The market views CLO collateral values as a critical "window" into the true economic value of private credit assets, highlighting the discrepancy between private and public market valuations.
• Portfolio Construction: Ideal portfolios should balance locked-up, gated private cash flows with liquid public assets to achieve uncorrelated returns and defensive income profiles.