Structured credit has gone through a significant evolution over the past 10-years to emerge as a stable, well-regulated and, in our view, attractively priced asset class.
With a more defensive profile than corporate credit, combined with compelling premiums, the asset class has notable appeal in today’s ultra low-rate environment.
Sector-specialist Luka Miodragovic provides a deep-dive into the asset class.
How large is the structured credit market and how is it split per collateral type? Which area is growing the most or is likely to grow over the next few years?
The market totals approximately USD2.5-3 trillion in the US and around USD500 billion in Europe.
There are some smaller subsidiary markets, such as Australian residential mortgage-backed securities (RMBS), but the US and Europe make up the core. The bulk of the assets are in residential and commercial mortgages. RMBS takes the larger share in both the US and Europe.
Collateralised loan obligations (CLOs) comprise around 25% of the total size and is one of the fastest-growing sub-sectors.
Elsewhere, auto loans (personal loans secured against your vehicle) have displayed notable growth in the US, surpassing mortgage loans for the first time in 2013. Alongside CLOs, auto loans are the only major sub-sector to have grown to exceed its pre-crisis size.
Aircraft lease asset-backed securities (ABS) are a notable emerging sector, which we’ve seen grow quickly over the last couple of years.
What’s the appeal of ABS for investors?
We believe ABS has several benefits over corporate debt, having a generally more defensive profile.
A key feature of ABS is that you are only tied to the performance of the collateral, not the issuing institution.
For example, if a bank originates mortgage loans and packages them into an ABS, the ABS investor is only exposed to the performance of those specific mortgages, whereas a corporate debt investor who buys the bank’s debt is exposed to the entire performance of the bank. If the bank becomes insolvent, the ABS can be sold to another entity and, as long as the underlying borrowers continue to pay their mortgages, the investment goes unscathed.
Conversely, the corporate bond bank investors are at risk of getting a write-down on their investment. Hence ABS are considered to have ‘bankruptcy-remote’ status.
A good example of this is that, to this day, we are still investing in UK RMBS originated and issued by Lehman Brothers, with all deals expected to be repaid at par as homeowners repay and refinance their mortgages.
In addition, aside from a couple of sectors, the majority of ABS are fully amortising. Whereas a traditional corporate bond might be issued for say, five years with no repayment due until the end of the term, ABS start deleveraging with repayments from the day they are issued. This actively de-risks the transaction from day one.
Some ABS are also backed by collateral that can appreciate in value, such as property. This reduces the risk of the investment over time as the rising value of the asset can be used to repay the loan should the original payment source fail for any reason.
Also, investing in ABS allows investors to capture a spread premium over other credit assets with comparable ratings and duration. This is how we have approached our investments in the portfolio currently, focusing on higher credit-quality assets with attractive risk-adjusted spreads.
What are the biggest challenges to investing in this asset class?
Structured credit is still evolving, therefore a primary challenge is that the structures and loans that are being originated are constantly changing.
With MBS, rather than monitoring the health of one company, you’re also exposed to how a large pool of people pay their mortgages. This exposes you to credit, macro and prepayment risk, which brings with it variability in cashflows and risks compared to more straightforward corporate bond structures.
Structures also change in reaction to risk-on/risk-off sentiment, where they can also become more conservative to match the mood of the market.
The other main challenge is regulation – it’s constantly changing both at the broad asset class level and in relation to all the industry sectors that we invest in. For example, in cities and countries that are looking to institute bans on diesel cars, the value of these may be far lower than projected and this may affect the credit performance of auto loans and leases in these jurisdictions.
Do you believe that investing in investment-grade structured credit can help de-risk a fixed income portfolio?
In my view, yes – it’s a relatively defensive sector backed directly by observable collateral. Investment-grade securities typically benefit from substantial structural subordination that provides a significant cushion to a pick-up in losses in the underlying collateral.
Furthermore, the spread durations in ABS and CLOs are relatively short. In Europe for example, the bulk of ABS is less than three years in spread duration and CLOs are typically four-to-six years in spread duration. The outcome is typically lower price volatility than corporate credit.
ABS also does not follow the wider moves of the market unless it’s a sustained sell-off or rally, so can help to reduce portfolio correlation on a shorter-term basis. For example, in July and August we saw a 15bps peak-to-trough widening and then equivalent tightening into September in the iTraxx Main corporate credit index while European ABS saw no major spread movement over the same period.
Looking ahead, what do you think is the biggest risk to the ABS market?
I’d say regulation is actually the biggest ‘risk’ for us. While improved underwriting standards have transformed the asset class and made it stronger, there are cases where well-intended regulatory moves risk damaging the market.
For example, the Irish parliament proposed a law that could impact the ability of banks and lenders to sell mortgages into special purpose vehicles (SPV) unless the borrowers give their consent, which would leave the lender without a funding source if the borrowers say no.
The Central Bank of Ireland, Department of Finance, Attorney General, the Banking & Payments Federation of Ireland and European Central Bank have all come out against the proposal but it continues to be debated in parliament.
Should it pass, it could effectively kill off the Irish securitisation market – something that even the large property crash that led to credit impairments in Irish MBS failed to do.
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