Structured credit
Considering potential opportunities in Significant Risk Transfer
3 min read 12 Sep 23
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A Significant Risk Transfer (SRT) transaction is a first or second loss protection purchased by a bank on a diversified pool of core lending assets, for example, loans to large corporations, as well as SMEs. Although the origins of the SRT market date back to the 1990s, it has only existed as recognised today since the introduction of Basel II in 2007. Here, we explore why now could be a good moment for patient investors to consider SRT transactions, and why this potentially compelling opportunity could be short-lived given where we are in the economic cycle.
Over the years, SRT transactions have become increasingly common, especially as banks, in general, need more capital for every unit of lending they carry out. Since the Global Financial Crisis, we’ve seen banks faced with tighter and more onerous regulatory capital requirements imposed by accounting standards and regulations such as IFRS9, as well as Basel III and Basel IV.
“With the generally fairly risk-off tone we’ve seen in credit markets for the last 18 months, recent transactions have appeared very attractive versus what we have seen historically.”
SRT transactions largely emerged as a way for banks to improve their regulatory capital position by means of reducing the risk weighting of the loan assets from a regulatory perspective, without having to de-recognise assets on the balance sheet. In other words, synthetic securitisation like SRT provides an effective way for banks to engage in risk-sharing transactions with non-bank investors without needing to raise equity or sell assets.
“One of the key things that really galvanised this market was around the middle of the last decade when the ECB issued a number of guidelines and rules for what they wanted to see within a significant risk transfer transaction to actually allow that capital relief for the banks,” explains James King, Head of Structured Credit at M&G Investments.
Risk and reward in Significant Risk Transfer
Although SRT transactions entail a high level of risk, they have tended to exhibit lower return volatility than other publicly-traded fixed income assets due to their private nature, medium-term oriented investor base and exposure to relatively stable performing bank loan assets. In sterling terms, we have recently seen SRT transactions pay out coupons of 10% and higher returns1, so investors could be significantly compensated for taking on the risk. Their return – which largely comes in the form of carried coupons – is mostly impacted by actual losses on the underlying loan portfolio, rather than down to market risk.
“There is a secondary market for SRT, but it's pretty limited,” says King. “Getting exposure to SRT transactions is not straightforward. It's not like moving into equities or corporate bonds, or indeed cash. You essentially have to build a portfolio, and it takes time.”
He adds: “With the generally fairly risk-off tone we’ve seen in credit markets for the last 18 months, recent transactions have appeared very attractive versus what we have seen historically.”
Why now for SRT?
According to King, a typical SRT transaction could now offer a better spread compared to those seen in 2021 or the last time there was momentum in the market in 2019. “It will be a better-quality transaction in terms of underlying collateral, and I may well have a thicker tranche, which means I've got a less volatile return profile,” notes King.
“But these transactions don't exist in perpetuity. They exist because, right now, the market is saying: ‘There is uncertainty, and we want to be compensated for these additional potential risks’.”
Considering where we are in the cycle, with all the various pockets of volatility, SRT transactions are generally factoring in the uncertainty. However, if risk appetites return, it could become more challenging to build a portfolio of SRT risk, in our view.
Many of the transactions currently being carried out are going to buy-and-hold investors, and we believe those investors could be enjoying returns from those assets for the next 5 to 8 years. In our view this market is still relatively under-invested, which is one of the reasons why spreads have remain so attractive. However, over time it is likely that this premium will be eroded as more investors come into the asset class. We believe these factors combined make it a very interesting time to be putting money to work in the SRT market.
Ultimately, SRTs are issued as credit instruments, with returns derived from the underlying loan pool. Therefore, the risks of losses on these loans are the primary concern of investors. However, investors can seek to mitigate these risks by focusing on diversified pools with lower individual borrower concentrations; partnering with large banks that have lending track records that pre-date the global financial crisis; and meticulously stress testing portfolios to facilitate a high probability of withstanding prolonged periods of economic weakness.
1M&G Investments, as at April 2023.
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The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested. Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast.
