Beyond traditional fixed income: Diversifying into specialty finance

Investors have increasingly looked beyond traditional fixed income and credit asset classes and allocated capital to private and structured credit. However, traditional forms of private corporate credit including broadly syndicated loans (BSL) and mid-market direct lending have been the de-facto destination, accounting for slightly over half of all private credit allocations, according to a Preqin 2024 report. As these markets mature, perhaps now is the time to ask whether investors should seek to further diversify their allocations? We believe specialty finance is an area that investors should consider diversifying into as they develop their allocations to private credit over the coming years.
 

What is the specialty finance opportunity?

Specialty finance or ‘asset-backed’ private credit (asset-backed finance) involves granular pools of assets, typically consumer and small-cap corporate/commercial loans and leases, credit and receivables financing, originated by banks and non-bank, ‘specialty’, lenders.

First, it is worth reiterating what the specialty finance asset universe comprises of as the range of assets that are generally considered part of the addressable opportunity set can be broad and varied – from well-established areas like consumer and mortgage finance to small business loans (working capital and other contractual cashflows), as well as transactions backed by ‘hard’ physical assets (equipment leasing, aviation) and esoteric asset classes.

The most scalable and secured areas of the current asset universe are granular portfolios backed by real economy loan and credit products – primarily from the world of consumer finance including residential mortgages and consumer loans. These refer to new loan origination or existing pools of back/legacy books of loans and receivables backed by consumer risk, and often a hard asset such as homes and cars as collateral. Most assets are also secured against – and have full recourse to – the borrower, and cashflows are linked to the performance of the underlying collateral and the ability of borrowers to pay back their loans. 

Getting granular

Many investors prefer to invest in performing loans due to the observable and highly predictable cashflows which they generate, while adopting a data-centric approach allows the ability to capture and process significant amounts of data on the performance of individual loans (which could total thousands if not hundreds of thousands of data points) through economic cycles and regime shifts, that can then be modelled and analysed to determine how loan pools are likely to behave under different scenarios.

An area primed for growth

The catalyst for the growth of specialty finance was the global financial crisis (GFC) in 2008, and specifically the structural changes in the lending landscape that have occurred amid the gradual phase-in of bank capital regulation (Basel III Framework) since the GFC, which has effectively pushed up capital consumption especially for large banks on their lending books based on the risk weighting of those assets.

The specialty finance asset opportunity has continued to grow and develop as banks have sought ways to manage their regulatory capital, optimise their balance sheets and boost profitability – engaging in portfolio sales (selling pools of assets in whole loan format or utilising tools such as synthetic significant risk transfer (SRT). To navigate the challenges, banks have also narrowed their lending remits and become more discriminate by moving away from owning the assets they used to own or selling down risks to manage pressure from higher risk-weighted assets and internal risk limits .

We believe that specialty finance is particularly set for growth in Europe owing to long-term structural drivers and enablers:
 

Bank deleveraging continues as capital regulations require banks to fund themselves with more capital and focus on balance sheet optimisation.

• Europe has a large, fragmented and overbanked marketplace and banks have historically struggled with lower return on equity (RoE) and profitability versus their US peers. Most large European banks have increased their common equity Tier 1 (CET1) ratios since 2017 and profitability and RoE have improved. 
  
  
• The bloc’s biggest banks appear well positioned to navigate the implementation of the final Basel III Endgame reforms, but specialty finance-type portfolio/asset sales and risk-sharing transactions like synthetic SRT are increasingly being utilised by banks given limited alternatives.

Consumer lending is evolving with the growing penetration of innovative, tech-savvy non-bank lenders in Europe. 

• These origination platforms and specialist lenders have embraced technology and advanced data capture to respond to the changing financial needs and behaviour of consumer (and corporate) borrowers more quickly than traditional banks that have lagged in terms of modernising technology infrastructure.
  
  
• Specialist lenders are filling the gaps banks leave, as well as creating markets of their own in new asset classes or origination channels that bypass the banking system altogether.
   

Why invest in specialty finance?

There are several reasons investors should consider investing in specialty finance, in our view. These range from the potential for attractive risk-adjusted returns, yield enhancement and diversification benefits.

Return enhancement

We believe the available yields within specialty finance are attractive in absolute terms, with many opportunities offering the potential to earn low teen to double digit returns, and relative to high yield public and private credit comparators. A key reason for this is that in addition to an illiquidity premium, a further premium can be captured due to the complexity, sourcing and origination expertise required to build and manage a diversified portfolio of specialty finance investments – together with less competition for assets. Investing in the asset class means investing in junior / residual (and lower mezzanine) securities / notes only, backed by very granular pools of assets.

Resilient collateral performance

Historical default rates of mortgages and consumer loans compare favourably with equivalent-rated corporate defaults across different macro and market climates – the average consumer has proved resilient in the face of headwinds (sticky inflation, cost-of-living crisis) supported by strong labour market trends and a social security net/fiscal support from UK and European governments. Equally, irrespective of the economic environment, residential mortgage borrowers, mobile phone customers etc are unlikely to readily renege on their contractual obligations given the essentiality of the underlying assets. Where arrears have been rising it has been concentrated in certain areas such as credit cards and non-prime borrowing segments.

This emphasises the need for comprehensive underwriting of deals and historical data on not only the performance of the assets but on the lender – to assess the underlying collateral and borrower behaviours to model key inputs such as defaults and prepayment expectations, which can impact the performance and economics of an investment.

Investor under-allocation

With BSL and direct lending representing the majority of private credit flows over recent years, many investors will be under-allocated to specialty finance. This relative lack of attention is supportive as managers do not face the same level of competition for assets and have an ability to negotiate on terms and other structural protections, which has maintained better returns for the asset class.

Diversification

Investment into a strategy that focuses on consumer asset-backed opportunities is a clear diversifier for many fixed income and credit investors, given already heavy exposure to private and public corporate credit asset classes. Specialty finance investments are intrinsically diversified as they consist of granular pools of individual loans, credit and other receivables (mortgages, credit card receivables, consumer loans, mobile phone contracts etc) and helps to avoid jump-to-default risk.

High cashflow, low duration assets

The majority of specialty finance assets tend to be self-amortising and short dated in nature with the weighted average life (WAL) of investments around 3-4 years (repayment profiles can range from 1 year to 7 years depending on the underlying collateral and the jurisdiction (eg short dated fixed rate mortgages tend to be more prevalent in the UK). Moreover, high excess spread components, combined with structural features, can typically result in attractive cash-on-cash returns on junior tranches of consumer asset portfolios, enabling managers to reinvest cash proceeds into new opportunities and ensures investments get de-risked relatively quickly as loans are repaid or prepaid by borrowers.

Assets are also typically floating rate (or swapped to floating) which can be seen as a benefit amid the higher-for-longer rate environment.

Thoughts on asset allocation

Exposure to high-quality asset pools

Specialty finance will not be an appropriate option for every investor. Given the limited liquidity of the market, there is a need for stable, closed-ended capital to maximise the potential returns from the asset class over time. By partnering with managers who have been investing in the asset class for a number of years, investors can gain exposure to harder-to-access, yet high-quality asset-backed opportunities from core banks and well-established non-bank origination platforms.

Diversification for most portfolios

Moreover, with many investors’ fixed income and credit exposure slanted toward the corporate side, investing in consumer specialty finance can provide much-needed diversification for most portfolios as part of an investor’s long-term strategic asset allocation, while providing a way to target higher risk-adjusted returns. We think specialty finance should be viewed as a complementary allocation alongside other high yield private and structured credit asset classes.

As well as dedicated specialty finance funds, these assets can be accessed through evergreen high yield structured credit strategies for investors who wish to manage a broader relative value portfolio by seeking exposure to private, less liquid areas of significant risk transfer and specialty finance alongside more liquid collateralised loan obligations and consumer asset-backed securities (ABS) markets.

A differentiated strategy

While specialty finance does share similarities with some private credit strategies – including high potential risk-adjusted returns, contractual income streams, lower volatility relative to equivalent-rated public comparators, ability to negotiate key structural protections – there is an important feature of specialty finance which is a powerful differentiator. Significant optionality exists in most specialty finance assets which can be an advantage on the liability side ie sourcing and structure of senior financing of the pool (public or private bank warehouse). As such the return profile is not as asymmetrical as traditional credit bonds and asset ownership can enable both value creation and options to maximise investment outcomes.

Comparison to direct lending

Specialty finance differs significantly from the more mainstream corporate direct lending market even though both have effectively emerged post GFC and been catalysed by the disintermediation of bank lending. 

A differentiated asset class

Specialty finance offers many attractions to investors seeking to diversify their credit allocations. Viewed particularly as a complementary addition to existing private credit allocations, it is sufficiently differentiated in its structure and risk/return profile to offer investors genuine diversification benefits and the potential to generate ‘equity-like’ low/mid-teen net internal rate of returns.

With the secular trends highlighted in this paper, we believe the specialty finance universe is set only to expand presenting even more compelling and diverse opportunities. 

Key risks associated with these asset areas/strategies: 

Credit risk: The assets may be exposed to the possibility that a debtor will not meet their repayment obligations.

Liquidity risk: The investments may be illiquid, as a result it may be difficult for the strategy to realise, sell or dispose of an investment at an attractive price or at the appropriate time or in response to changing market conditions.

Concentration risk: Due to a limited number of investments, the strategy may be affected adversely by the unfavourable performance of a single issuer.

Equity risk: As equity is subordinate to all other claims into an underlying investment, the strategy may be exposed to the possibility of a low or zero recovery on some of its investments.

Prepayment risk: Loans may be prepaid by issuers at short notice, as a result it may be difficult for the strategies to locate and reinvest capital at an attractive price or at all, which may affect the strategies adversely.

Derivative risk: The use of derivatives for non-hedging purposes may expose the strategies to a higher degree of risk and may cause larger than average price fluctuations.

Currency risk: The strategies may be exposed to currency rate movements.

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.