Demystifying the world of structured credit

An expanding asset class

Outstanding volumes of ABS and CLO issuance have grown in recent years, while tighter capital and regulatory constraints placed on retail banks in the wake of the GFC have given rise to new opportunities for external investors to gain access to the core parts of banks’ lending books as banks have reassessed the lending segments they were prepared to commit their capital to. They either withdrew from or reduced exposure to several credit areas creating a gap which private, non-bank lenders eagerly stepped in to fill. Hence the steady rise of private structured credit markets post-GFC.

For investors this means there is now a broader spectrum and a greater capacity, of addressable opportunities within structured credit for them to invest in. We see growth only set to continue from here given the acceleration of the megatrends underlying the growth and expansion of this asset class. And, in our view, the attractions of structured credit remain as compelling as ever. It can potentially provide investors with higher risk-adjusted returns relative to other similar rated fixed income alternatives. For those looking for diversification, the ability to access differentiated asset exposures not normally found within traditional fixed income portfolios and potential returns that are largely uncorrelated with other established asset classes can prove useful during periods of broader market volatility. In fact, the asset class can offer a comprehensive set of attractions which investors may wish to consider.

A range of compelling attributes

The benefits to investors considering an allocation to structured credit fall mainly into the categories of returns, diversification, losses and structural protections:

Returns: Potentially greater return potential – both absolute, and relative to other fixed income and credit asset classes together with a more muted volatility profile. This return or yield premium is typically due to the (perceived) complexity of investments and reduced liquidity, although the European ABS market has proved to be consistently more liquid than many had presumed.

Diversification: Structured credit products are inherently diversified as they usually comprise hundreds or even thousands of individual consumer or commercial loans. As a result, there is a wide spread of individual borrowers, across loan types and geographies, leading to cashflow sources being highly diversified and granular. 

Losses: European structured credit markets today are more transparent thanks to the efforts by regulators and the ECB to ensure a high degree of loan-level information in each transaction. This allows investors to analyse the transaction before buying to ensure adequate compensation for the risk, and to ensure sufficient downside protection. Historically low loss rates for structured credit asset classes in Europe including ABS and CLOs, particularly relative to the experience of US equivalents, are also a factor of robust loan underwriting standards post-GFC.

Structural protections: Key structural features are typically built into transactions helping to cushion investors against potential losses while investments can provide recourse to the borrower as well as the asset. Structured credit securities or notes are normally sold as ‘tranches’ – securities sold in different categories according to the position in the capital structure: senior, mezzanine, junior and residual with the bonds backed by the cashflows from the asset pool and bankruptcy remote from the bank or lender. Each tranche category has a different risk/return profile together with a different credit rating assigned, with investors able to choose which one best serves their investment needs and matches their risk appetite. Further buffer exists as more often the underlying pool of loans has more assets than liabilities ie they are over-collateralised. In addition, often the interest received on the pool of loans is greater than the liabilities.
 

There’s always risk...

Of course, structured credit will not be the correct route for everyone, and risks exist as with any asset class. There’s no escaping the fact that some structured credit products ie, those with exposure to the more illiquid assets comprising the investment universe, can offer limited or no liquidity to investors. For some investors this may be a major hurdle. Thankfully products exist today offering both daily and monthly liquidity. 

Structured credit is also not immune to changes in interest rates. Floating-rate in nature, they are attractive when interest rates are rising, increasing interest income. But of course, income receipts can equally decline when rates start to fall.

As with all credit investments, there remains the risk of defaults turning into actual losses for the investor should borrowers default on their debt payments en masse and the assets underpinning the loans become impaired.

While there is a degree of complexity relating to the construction of a structured credit security, most often the nature of the underlying income-producing assets are not. We believe the potential to capture higher risk-adjusted returns, irrespective of market conditions, together with its clear portfolio diversification benefits merits structured credit being a prime consideration for fixed income investors looking to add another dimension to their portfolios.