Diallo does not find it surprising to see allocations to structured investments growing from institutions.
“As these institutions get more and more expertise and independence, they have access to that new asset class. Just for diversification purposes, if you have a new asset class that you haven’t allocated to, by going from zero to even 1% is [an] added benefit. The less sophisticated institutional investors are now getting enough sophistication,” he said.
Diallo further implied that diversification is really the “low-hanging fruit” in the space, finding that new investors diversifying their portfolio further with something that is uncorrelated to what they already have is a “plus.”
Nathan Wong, v.p. and investment consultant at Callan, views structured credit as a “pretty good diversifier” within a fixed-income allocation.
“There are a number of different directions you can go in structured credit to fit a number of different investor profiles from a high-level perspective just in terms of diversification,” Wong said.
An Introduction to Structured Credit report presented to the Santa Barbara County (Calif.) Employees’ Retirement System from PIMCO noted that “the $11+ trillion structured markets are often overlooked, but can provide diversifying sources of returns.”
Several U.S. pension plans and nonprofit institutions have disclosed first quarter investments in the structured credit space as either first-time allocators or through existing relationships with their respective credit managers.
The Ohio University & Foundation committed to structured debt manager OrbiMed Advisors last month, the Virginia Retirement System made a $350 million commitment to credit manager HPS Investment Partners in February and the City of Hartford (Conn.) Municipal Employees’ Retirement Fund committed $15 million to a fund of structured product manager VWH Capital Management in January.
Institutions are “getting more expertise, but at the same time, the asset class is getting more transparency, it’s getting more alignment of interest and it’s more regulated. That also helps boost an investment,” Diallo noted.
Structured credit products issued up until the Great Financial Crisis were lacking in certain elements, but have made an improvement toward more transparency, regulatory disclosures and the alignment of interest, according to Diallo.
“Regulators have now put big orders on managers to make disclosures and so at least investors that have the capabilities could analyze the risk. Without disclosures, even if you’ve got capabilities, if you don’t have that information, you just can’t analyze it,” Diallo said.
“All of these combined makes institutional investors that usually are the last ones to respond to new trends now have access to that asset class. Without the regulatory framework, even if they have the capabilities in house to do it, that would still be an obstacle,” he continued.
Aegon Asset Management Head of Structured Finance Jim Baskin agrees that the space is in a different position today than where it was before the Global Financial Crisis.
“There’s been a lot of regulation, a lot more attention on rating agencies to be more proactive in their risk assessments of these asset classes and then investors have also learned a lot from the financial crisis,” he said.
“What we see today is increased credit enhancement across almost all sectors relative to before the financial crisis and we have seen very consistent loan underwriting, if not much more conservative than what we saw pre-crisis,” he added.
Areas To Watch In The Space
While the space can often be overlooked, the industry finds value in a number of sub-asset classes underneath the structured credit umbrella, investors said.
Aeon’s Diallo indicated that the firm was looking at where it could generate regular cashflow with the least amount of risk, and so they “zoomed” into structured credit as they realized they “could actually get security and secured contracted cash flow over a long term.”
Diallo highlighted two main buckets in the structured credit space: real estate, which offers products including collateralized loan obligations of commercial real estate, commercial mortgaged-backed securities and residential mortgage-backed securities; and the non-real estate or corporate side, where opportunity lies in securities such as corporate CLOs, aircraft and transportation-type leases.
Areas to watch for within the structured credit market in 2022 include CLOs, CMBS and RMBS, according to recent research from Aegon, with Baskin indicating that the firm likes housing for two primary reasons.
“We think the consumer is in a really good spot coming out of the financial crisis. They’ve demonstrated a continual de-leveraging of their balance sheet and really showed that the consumer was very resilient and that their de-leveraging over the last several years has been a strength to that area,” he said.
“The other area that is really beneficial to housing is just the general shortage of housing that we’ve seen both structurally and demographically. We see an increasing need for housing and we really have not built enough single-family housing to support the demand. When you put a healthy consumer with that structural need for housing, what we have seen is home prices have increased and we think that that would translate into a real opportunity and great tailwinds for credit risk,” Baskin continued.
Callan’s Wong agrees that there are positive trends in the real estate portion of structured credit.
“Within RMBS and CMBS, I think there are certainly some positive trends that are happening when you talk about non-qualified mortgage exposure, non-agency RMBS. I think a lot of those are benefitting from rebounds and housing prices generally over the past several years and that certainly has continued to go up during the pandemic. A lot of the reperforming loans that have come back into the market are performing a little bit better. Commercial real estate certainly was dramatically and negatively impacted during the pandemic, but I think they’ve certainly found some support more recently,” he said.
Wong finds that since structured credit encompasses many different securities and sub-asset classes, it is appealing to various investors as a “catch all.”
“Whether you want to be senior in the capital structure, you want to take a little bit less risk and perhaps commensurately less coupon, you can get that. But if we’re diversifying a high quality existing fixed-income portfolio and you felt like you want to reach for a little bit of yield, there’s certainly a lot of opportunity within lower parts of the capital structure within each of these securitizations,” he continued.
ZAIS Group Head of Structured Investments Denise Crowley indicated that if you look at debt tranches of select structured products, many offer excess spread relative to more on-the-run liquid credit.
“If you look at BB CLO tranches relative to high-yield BBs, you’re getting about two times the spread on CLO BB’s relative to high-yield BB-rated corporate bonds. Certainly, in terms of the amount of compensation that you’re offered on the CLO BBs, the coupon at least is double that of high-yield. I think that’s something interesting that the market takes into consideration when evaluating structured credit or more complex/less-liquid credit,” she said.
Additionally, “If you look at the cash flows of structured products, particularly in the more subordinate tranches, you tend to pick up a lot of cash flow upfront, so they tend to be high cash on cash-type instruments,” she continued.
Floating Rate Appealing In An Inflation-Hiked Market
The industry finds that structured credit products have been of interest partially due to their floating rate nature — which changes periodically as opposed to a fixed rate — in a high inflation market currently being experienced.
“The fact that you actually have a floating component to your rate is going to be very interesting, especially in this high inflation area that we’re seeing globally,” Diallo said.
Baskin noted that there is a “fairly large grouping of assets that are naturally floating rate, and so you get to rise with interest rates if that comes about.”
ZAIS Group’s Crowley thinks this holds true in the CLO market or asset backed lending space, particularly where “you have floating rate assets and liabilities.”
“At least in terms of the first order impact, there’s not much real interest rate sensitivity. Leaving aside the impact of floors on loans, which can be a factor especially when rates are lower, they have short effective durations, so they don’t take on a lot of interest rate risk because both the assets and liabilities are floating rate,” she said.
An environment in which the Federal Reserve is embarking on a tightening path has left many investors concerned about higher interest rates and the impact on fixed-income, especially this year, Crowley indicated.
According to Diallo, one key defining factor of structured credit is that “it is always floating base.”
“It’s always a base rate plus a margin. When central banks are tightening like they’re doing right now, you aren’t being impacted, you are being paid a margin in excess of that base rate, which goes up. A base rate goes up versus traditional fixed-income bonds and when we would buy, it would have that inverse relationship,” Diallo said.
Floating rates are catching the eye of investors as they allow for the diversification of duration between fixed and floating assets, according to Aegon’s Baskin.
“Structured finance is a really interesting asset class to diversify away from other traditional fixed-income products like corporate credit or high-yield or emerging market. It presents a different set of opportunities; it allows you to diversify away from bankruptcy risk and it allows you to express themes really specifically because there are so many different asset types and each one of those asset types are tranched into really low risk opportunities, like AAA bonds, all the way down to higher risk opportunities in the below investment grade space,” Baskin said.
Wong, who specializes in fixed-income within Callan’s global manager research group, agrees that the fixed versus floating nature is an added benefit for structured securities.
“A lot of the RMBS will be fixed, but a lot of CLOs, certain CMBS securities, do have floating rate exposure and so to the extent that rates start to go up and continue to go up, I think you can see a bit more of a demand for floating rate securities that aren’t as affected by the rising rate environment or at least will stand to benefit from some of that increase in rates such that they get that floating rate exposure,” he said.
Crowley thinks the fact that much of the structured product market being floating rate makes the space compelling.
“From a rates and inflation perspective, structured products in general are a good area to look for opportunities given their typically high current cash flow, low effective duration and many good opportunities can be found that I think will likely weather those storms better than perhaps many other sectors out there,” she said.
Sustainability In A Structured Portfolio
A recent study from Aeon shows that 86% of U.S. and European institutions believe there will be more new structured credit issued in 2022 than there was in 2021. As issuances rise, the need to meet the ESG demands of institutions becomes more prevalent.
“A lot of [institutions] are setting up ESG committees and some are even committing to net-zero objectives over the next five or 10 years. The entire investment universe is under scrutiny from an ESG point of view and if they are going to increase their allocation to [the space], structured credit originators and managers have to respond to that, and therefore we need to look at CMBS offerings or CLO offerings that encompass ESG strategies and you’re seeing that,” Diallo said.
The Structured Finance Association discussed the absence of a standard framework in securitization in recent research, finding it has been a challenge as only 6% of issuers were providing ESG-related data for their securitization transactions in 2020.
But there is hope as the research indicated that one-third of respondents to the 2020 survey had plans to evaluate or develop plans to provide ESG information and SFA is addressing the disconnect as well.
“To reap the benefits that standardization would bring to the securitization market, SFA has established an ESG Initiative to develop an ESG Disclosure Framework specifically for the structured finance market to address its unique considerations and needs including disclosure standards for each underlying asset class,” the report stated.
Already a signatory to the United Nations Principles for Responsible Investment, ZAIS Group is seeing more of a focus on sustainable investing and ESG in selecting portfolios.
“Primarily, we look at environmental sustainability and transitioning to a lower carbon future, but I would say we’re also focused on social and governance factors as best practices in this realm usually indicate healthier companies. I think that’s an area where we’ve seen a lot more interest and growth and certainly, we’ve taken a lot of time to invest in personnel, analytics and in technology that enables us to perform that work,” Crowley said.
Baskin finds that structured finance is “clearly” in the early innings of providing sustainable solutions, but also thinks the industry will be surprised with what the space can do in this area thus far.
“Europe is much further along in [sustainability than the U.S.], but, in equities and fixed-income, I think we all got the wake-up call on ESG.” Baskin said, noting that “structured was no different” as there are “several asset classes that are pushing into this area.”
“There are now programs associated with government agencies to help finance energy-efficient homes and we have a large solar panel residential solar market that is emerging in the ABS space. In commercial real estate, large trophy assets are getting certified based upon their energy use, which is all driving into a sustainable structured finance marketplace,” Baskin continued.
Aeon is focused in areas where structured credit could potentially help and innovate to be more sustainable, according to Diallo.
“On the commercial side, for example, [Aeon is] making sure that areas that are technically deprived [of] a little bit of investment, get higher scoring from a social point of view and allow lending in those areas. On the environmental side, [we’re] making sure that all the buildings have energy efficiencies. It could be in renewable energy power, it could be in the material that is being used, it could be the carbon footprint. On the residential side, it is going to be on the S element where you’re looking at targeting with the affordable housing, targeting borrowers that might need a little bit of a boost from a social point of view or a socially deprived area,” he said.
“On the corporate side, it’s [about] pushing these corporate borrowers into sustainability. On the SME side, we’ve got an online tool that we push our borrowers into signing up to and it tells them to listen to the UN PRI guidelines and tells them how they currently score based on what they are doing, but also helps them by giving them advice to what can be done for them to improve that and get towards those sustainability goals over a period of time. We track that along with other variables, such as the amount of jobs that the lending has created and so on and so forth,” he continued.
While structured investments within a portfolio can transition to become more sustainable, there are challenges that can arise, and Baskin feels the challenge to this is standardization and having an experienced team.
“What constitutes a green bond in structured finance? What constitutes a social bond in structured finance? And what reporting is coming from these programs so that the ESG-minded investment professional can really look at this pool of assets and make sure that they’re getting the right impact that their investment objectives require? I would say our market is still trying to figure those things out. You don’t have consistent reporting along these lines,” Baskin said.
“The way to overcome that right now is really having experienced research staffs that are both coupled with the credit group so that they really understand these businesses, they really understand the underwriting strategies and we’re really producing investments that are meeting those ESG goals,” he continued.
Wong feels a lot of it comes down to the skillsets of managers and how they source the opportunities and diligence them.
“I think more managers are getting into the space, but it’s not necessarily a skill set [that] can be organically developed overnight. Giving their existing managers the expanded guidelines if they’re willing to take that risk and they think their manager can do it, but if not, then finding a manager that does do it well and giving them the ability to take advantage of opportunities that are not necessarily in the benchmark, but certainly are investable and a little bit less correlated with the market,” he said.
A Complex Asset Class With Limited Expertise, Risk
The industry is adamant about the opportunities that lie in structured credit products, however, the complexity of the underlying markets is an obstacle for some investors.
Crowley believes people find it to be complex because a lot of expertise is needed to understand the space.
“You have to be able to do fundamental and, in some cases, quantitative analysis and have a lot of experience on the underlying credits. And you’re going to have probably quite a number of credits to look at, so you have to have some broad expertise, I would say, to be able to do that analysis,” Crowley said.
“There are many different things that drive performance of structured product tranches. Obviously, the performance of the underlying assets matter but, there are liabilities in place and those cash flows get divided out. You could have certain tranches get cut off from receiving your anticipated cash flows if defaults go up by a certain amount, for example, and they start violating triggers. It can get somewhat complicated in that you’re looking at this pool of assets and there is some path dependency to the expected cash flows of the liabilities, based on the performance of those assets,” she continued.
Crowley further indicated that the space requires a lot of expertise since these pools of assets are broad.
“In every CLO, you have over 100 corporate issuers represented. Similarly, in CMBS, if you’re going to look at CMBS, you have to have a fundamental, bottoms up approach to the properties backing loans that are being securitized. So, there is a lot of expertise needed in evaluating these things, but I do think the products themselves are fairly transparent and if you have the capability of doing that analysis and you put those pieces back together, you should be able to come to some reasonable conclusions about how various tranches of securitization are likely to perform across a range of possible scenarios,” she said.
Callan’s Wong indicated once more that difficulty in sourcing opportunities and doing the appropriate diligence can be a cause for concern.
For example, “Not everyone can underwrite an aircraft lease securitization. It certainly takes people that have expertise in different areas of the market, whether you’re talking about aircraft or commercial real estate, non-qualified mortgages, CLOs, things like that. These are all very different, unique asset classes on their own that all happen to be structured credit securities, but at the underlying level, have very different risk characteristics,” he said.
Wong finds investors need to find the right partners with expertise in the nuanced subject matter.
“I think that is certainly always top of mind for us when we have clients that want to discuss this or introduce it to the portfolios, make sure you find the right asset management firm and/or team that can do this and do it well,” he said.
For investors that are looking to select a manager in the structured credit space, Crowley thinks they need to look carefully at how long the manager has been investing in the products.
“Do they do it as a dedicated business? How did they fare through various risk-off periods? Were they around during the Global Financial Crisis and other times during which we had economic contractions and large declines in the market? How did they fare, what did they do, what did they learn? Obviously, their performance matters. You have to look at the team, the experience of the team, how many people they have analyzing these products. There’s a lot of different underlying asset classes. What kind of process do we have around analyzing these products? How do they think about them? How do they track them? These are all important things here to think about when selecting a manager,” she said.
Interested institutions should look for an experienced manager that has seen how the asset class performs across multiple cycles, according to Baskin.
“This will mitigate that concern quite a bit because you’re dealing with an asset manager that can navigate and rotate through the various asset classes in order to achieve better risk-adjusted returns. We saw this in the Global Financial Crisis. A lot of these sectors run in cycles and we saw this in the mortgage space where loan underwriting deteriorated and the structuring of those mortgage loans deteriorated with lower and lower credit enhancement, as we were approaching the financial crisis. An experienced asset manager can identify where an asset class is in its underwriting cycle and hopefully navigate a client out of that asset class and into something where there are better risk-adjusted returns,” he said.
Additionally, structured credit is not an asset class well suited for indexing because of the desires of investors to rotate within investment pools.
“There are generally always opportunities in the structured finance space, but I wouldn’t necessarily take a static view of X percent RMBS, X percent CMBS, X percent ABS. I would let a manager help you rotate through those asset classes as they become attractive,” Baskin continued.
Crowley indicated that because the space involves a known pool of assets, it can be much more transparent than investing in, for example, the equity of a company where investors do not know all of the inner workings.
“You will likely get some information released to you, but there’s a lot of things you probably still don’t know. In a CLO or CMBS, you’re going to know what the underlying assets are. You’re going to know exactly how the cash flows of those assets will be divided up under a range of scenarios, so there’s a decent amount of transparency,” she said.
In an environment like the GFC where most if not all correlations went to one, Wong stated that the space is not a “magic pill” that is going to be uncorrelated in all environments.
“There’s certainly a level of risk here. You’re exposed to underlying cash flows. A franchise restaurant is not immune to an economic slowdown [and] loans to consumers [are] not immune to an economic slowdown. While the correlations generally look lower, it’s not certainly always going to be the case,” he said.
A lot of structured securities such as CLOs performed strongly during the GFC and continue to perform well despite a lot of corporate credit exposure at the underlying loan level, according to Wong.
“I think correlation risk is there, but we’re continuing to see that these have exhibited some pretty resilient performance over the past few crises,” he said.
If institutions are looking at subordinate tranches of structured products, Crowley thinks they need to face the fact that there can be idiosyncratic risks in certain portfolios.
“If there’s a CMBS portfolio that has large exposure to one property that happens to not perform as expected, even though the general macro picture may be okay, that deal can suffer more losses than the average CMBS transaction,” she said.
Portfolio Fit Dependent On Investor, Resources
Given the vast yet nuanced space, the industry experts do not necessarily feel structured credit is appropriate for each investor unless the right managers, systems and alignment of interest are in place, however, the space is always evolving for interested investors.
The number one hurdle of structured credit is that few investors can do it and do it well, according to Wong.
“If you’re going to disaggregate the Agg, which I don’t think is for every investor, that’s one way to get it into your portfolio,” he said. “It becomes more difficult to rebalance the portfolio, monitor it and making sure that you have the right exposures versus other things that you want in the portfolio, whether it’s high-quality U.S. treasury or government exposure or corporate credit. When you have to oversee all of those weights and allocations yourself, it becomes pretty difficult if you don’t have all the appropriate systems and oversight to make sure all of your exposures are right where you want them to be.”
Diallo believes in the alignment of interest between an investor and the manager with which they choose to partner.
“If you’re investing your capital like we do on a more junior basis, as we always take the first loss in our investment to show our belief in our input, I think that alignment is really powerful. That alignment of interest beyond what is contractually meant to be done, due to the securitization rule. If you go with managers that actively seek to be invested in potentially the most junior tranche, then you set yourself up for less surprises down the line,” he said.
Crowley sees the importance in weathering volatile periods with the appropriate managers.
“You want to be able to withstand or weather those volatile periods without having to liquidate a large number of your positions. Basically, the theme there is you have to be careful particularly in more subordinate tranches of structured products of market-to-market volatility and illiquidity,” she said.
“Try and make the investment through vehicles with managers that will have the ability to withstand volatile periods without having to liquidate assets to a large degree, you do not want to have a large mismatch in liquidity of the assets versus the liabilities,” she continued.
While structured credit comes across as a complex investment opportunity that only select investors should take advantage of when their interests are aligned with the market’s top managers, it remains an “interesting area that people should keep an eye out on as there’s always something evolving in the space,” Baskin said.