Value in Private Student Loan Credit
Student loan asset-backed securities (ABS) continue to be one of the most unloved sectors in structured credit. Many institutional investors avoid the sector altogether due to policy risk and concern that broad actions by the Consumer Financial Protection Bureau (CFPB) could lead to material amounts of principal forgiveness and term extension. Under the Obama Administration, the CFPB never took steps to implement large scale principal forgiveness and stated they had no intention of doing so. Under the new Trump Administration, this type of policy shift is even more unlikely, as regulators have been moving the other direction and scaling back their interference in certain aspects of the financial markets. However, the CFPB was successful in working with servicers to improve their operations and communications with borrowers, which has led to increased involvement in modified repayment plans for borrowers. In general, this has lengthened the terms of the underlying loans.
This activity has led to some downgrades in the sector, as certain rating agencies became worried that debt tranches wouldn’t be paid off before the tranches reached their legal final maturity dates. Navient, one of the largest servicers in the private student loan credit space, worked to counter these downgrades by calling its deals in some cases and gaining bondholder approval to extend the legal final maturity dates in others. However, the rating agencies have been slow to reverse the downgrades, even after the success of these legal final maturity extensions.
From a credit perspective, the trusts in the private student loan space — particularly those issued by Navient and Sallie Mae — have demonstrated very high credit quality. The underlying borrowers are typically characterized by prime FICO scores and high co-borrower support, with co-borrower percentages sometimes even exceeding 90%. This week’s chart also shows how delinquencies in the space have stabilized over the past 15 years, while the overcollateralization in post-crisis private student loan deals builds quickly and remains high. This removes some of the credit concern in the sector and allows investors to focus on the question of how to model prepayments in an extending asset class. While this sector has participated in the broad rally in credit, there are still some unique convexity opportunities in this space, particularly in legacy Federal Family Education Loan Program paper, where bonds can still be offered at attractive discounts.
The policy risk associated with student loan ABS is frequently misunderstood — enough to keep some investors out of the sector altogether. However, digging a little deeper on the sector often reveals clean credit profiles and improving fundamentals. Extension risk has become a more prominent concern as more borrowers take advantage of modified repayment plans. If investors can get comfortable with how to appropriately model prepayments in the sector, then the asset class has something to offer to investors who continue the difficult search for value in the current fixed income environment.
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