By the Numbers
Gauging the relative value of rental car ABS and sponsor debt
Jason Delanty | May 5, 2023
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
The credit risk in rental car ABS overlaps significantly with the credit risk in the securitization sponsor’s own debt. Both ultimately depend on the ability of the sponsor to generate enough cash from the rental fleet to service the debt. But the ABS has structural protections for the investor that arguably make the ABS risk more transparent. Considering the generally better rating of rental car ABS compared to the sponsor’s unsecured debt and the small loss of spread, the ABS looks like better relative value.
The link between rental car ABS and the sponsor’s unsecured debt
For practical purposes, one can think about rental car ABS as secured by roughly the entire pool of the sponsor entity’s operating assets. That asset, broadly speaking, is the cash flow generated by a fleet of vehicles and the value of the vehicles themselves. A special purpose entity owns the vehicles and leases the vehicles to the sponsor—for example, Avis or Hertz– entitling the trust to monthly debt payments secured by operating cash flows and the value of the vehicles. The SPE issues debt backed by the lease payments, the rental car ABS. This means the sponsor has tremendous incentive to make the lease payments, otherwise it loses the very asset the company needs to operate. Even in bankruptcy, the estate has incentive to continue making lease payments to protect the value of the enterprise.
Ultimately, credit risk in rental car ABS ends up looking a lot like your credit risk in senior secured debt, with noteholder credit exposure to the sponsor’s ability to continue operating and generating the cash flow needed to pay debt. However, rental car operators do not have outstanding senior secured debt and instead issue unsecured debt. But to better understand the relative value opportunity between rental car ABS and the unsecured debt of the sponsor, it is important to understand how investors in rental car ABS get protected by the structure.
Rental car ABS uses a sequential-pay, senior subordinate structure with offered securities typically ranging from a senior ‘AAA’ tranche down to a ‘BB’ note. The two rental car ABS sponsors—Avis (B1/BB-) and Hertz (Caa1/B-)—both carry speculative-grade unsecured ratings. The usual term structure for newly issued bonds is either a 3- or a 5-year note with a revolving interest-only period followed by a 6-month amortization window (Exhibit 1).
Exhibit1: Rental car ABS structure overview:
Rental car ABS collateral can be divided into two categories:
- Program vehicles, or cars acquired from a manufacturer with an agreement for the manufacturer to repurchase or guarantee a depreciation schedule, and
- Non-program or risk vehicles
Program vehicles do not put investors at risk if the value of the used vehicles—also known as the residual value—falls. The manufacturer bears that risk. However, non-program vehicles, which represent roughly 98% of trust collateral for both Avis and Hertz ABS as of April 2023, remain vulnerable to wholesale vehicle market pricing.
To protect noteholders against losses from lower-than-expected residual value, rental car ABS is structured with monthly mark-to-market tests for non-program vehicles. These tests compare fleet market value—based on third-party data sources such as NADA or Black Book—to the depreciated value of the vehicles estimated at the outset of the securitization, also known as the net book value or NBV. The mark-to-market test measures the ratio between the lowest 3-month average value of the vehicle fleet over the trailing year and the NBV. Generally, if mark-to-market is greater than NBV, the deal passes the test, with any test failure triggering an injection of new collateral to satisfy the deficit. This test is regularly assessed, allowing it to reflect continual changes in vehicle market value.
The disposition test, an assessment of realized losses relative to NBV when the fleet operator sells vehicles, incorporates sales data for reported ‘measurement months’ to determine the average loss figure used in its calculation. A ‘measurement month’ is defined by a minimum number of monthly unit sales, and the test will use the most recent three months that reach or exceed the threshold.
Though the mark-to-market and disposition tests may be imperfect measures of fleet liquidation value, they are designed to account for any unexpected depreciation of the fleet. If a securitization fails one of these tests, the sponsor has to assign cash or more vehicles and their cash flows to support the trust. Any failure to increase enhancement to the required levels would result in a series amortization event, and eventually collateral liquidation.
Rental car ABS are also supported by dynamic enhancement mechanisms to account for the evolving composition of a rental fleet as vehicles are sold from and purchased for the trust. Collateral support is calculated by taking the sum of the credit enhancement requirements across program and non-program vehicles, as well as vehicle types and manufacturers. As the fleet mix changes over time, so too does the required enhancement, ensuring that breaches of vehicle concentration limits are accompanied by corresponding adjustments to the available credit support. This ultimately helps insulate noteholders from collateral quality deterioration throughout a series’ outstanding term.
Comparing ABS to the sponsor’s debt
The best relative value comparison involves the lowest rated class of rental car ABS against the unsecured debt of the sponsor. Looking at Avis’ rental car ABS subordinate pricing relative to the unsecured high yield notes, a 29 bp spread difference between the recently issued ABS note, AESOP 2023-4 C, and the senior unsecured note of comparable duration, CAR 5⅜ 03/01/29, presents an attractive opportunity for investors to rotate into an investment grade asset at a very modest give-up in the context of recently observed BBB/BB rental car ABS differentials. Though Avis has not recently issued any ABS below investment grade, Hertz priced a ‘BB’-rated, 5-year D tranche in February at 545 over the interpolated Treasury curve, 235bp cheaper than its ‘BBB’ C tranche (Exhibit 2).
Exhibit 2: Moving high yield debt to ABS improves rating at a small spread concession
Using single-name CDS to gauge ABS value
As previously mentioned, rental car ABS is somewhat unique among ABS sectors in that, structurally speaking, it more closely resembles a secured corporate financing transaction. The inextricable linkage of sponsor creditworthiness to the performance for both the ABS and unsecured note programs invites space to think about the appropriateness of insurance against sponsor default as hedging tool. A synthetic hedging strategy for subordinate ABS risk is beyond the scope of this piece, but by establishing a valuation framework between ABS and single-name CDS, investors may find it useful in assessing the contextual cheapness of a sponsor’s securitization program versus the cost of insurance.
As it pertains to the current relative value argument, Avis’ subordinated ABS pricing spreads—using new issue pricing for ‘A’ subordinated notes—as a percentage of the cost of insurance, measured by the 5-year Avis CDS spread for the same pricing date, are currently trading at multi-year wides. (Exhibit 3)
Exhibit 3: Ratio of new issue 5-year AESOP to AVIS 5-year CDS
For portfolios that manage rental car operator credit risk, either through ABS or unsecured high yield exposure, an attractive pricing landscape for rental car ABS has skewed the relative value argument in favor of the higher-rated securitized bonds, especially when considering the main source of credit risk in both debt programs. The current value proposition for subordinated rental car ABS versus the unsecured notes looks particularly interesting, and the protective features supporting the rental car company’s ABS complex, even for subordinated noteholders, argues for rotating into the higher quality, securitized instrument.