Perspective

What is Structured Credit?

Structured Credit includes non-traditional bonds securitized by specific pools of collateral, such as residential and commercial mortgages, consumer loans or commercial loans. Figure 1 summarizes the major sectors. Through a process called securitization, loans with similar characteristics are purchased and pooled in a trust-like entity known as a Special Purpose Vehicle (SPV). The SPV then issues securities backed by the principal and interest cash flows of the collateral pool that exhibit a variety of characteristics in terms of coupon, maturity, price, yield and credit quality.

Figure 1: Major Structured Credit Sectors

Key Features and Potential Benefits of Structured Credit

Structured Credit can benefit investors in a number of ways, including the potential for relatively high risk-adjusted returns, attractive monthly income, portfolio diversification, and limited exposure to duration and credit risk.

Non-Indexed and Inefficient: Because non- agency structured credit exists outside of major indexes, it may provide investors access to fixed income market segments that have not been commoditized by major benchmarks and ETFs. In addition, the inefficient and complex nature of the space allows for highly experienced managers to exploit price dislocations.

Floating Rate: Many structured credit products offer a “floating” or variable rate. Similar to more commonly known bank loans, the coupon offered is typically a spread above a benchmark rate, such as LIBOR. This can be particularly appealing when interest rates are rising.

Risk-Adjusted Yield Premium: Structured Credit typically offers investors attractive yield per unit of duration relative to traditional fixed income. (See Figure 2)

Tranched Risk: While the collateral is made up of pools of loans with similar characteristics, Structured Credit securities are typically tranched into a capital structure through a process known as subordination (See Figure 3). Each tranche is offered separately, and each has a distinct risk/return profile. The more senior tranches typically have less exposure to credit risk and, as a result, have lower yields. Conversely, the more junior the tranche, generally the higher the levels of credit risk and yield. (See Figure 3) This allows investors a broad spectrum of options to satisfy their risk/reward preferences.

Credit Enhancement: In addition to subordination described above, structured credit may offer another advantage over traditional fixed income: credit enhancement, through overcollateralization and excess spread. This can help mitigate credit risk and can provide a buffer against loss.

Diversification: Structured credit potentially offers diversification at both the loan and the portfolio level. At the loan level, structured credit securities are typically collateralized by a diverse pool of similar assets such as loans. This diversifies the collateral pool, reducing idiosyncratic credit risk of all tranches in the deal. At the portfolio level, investors can gain exposure to a part of the fixed income market that exists outside major indexes and ETFs. In addition, structured credit has historically had low correlation among its sub-sectors as well as to traditional fixed income sectors.

Figure 2: Structured Credit Sectors Provide More Yield Per Unit of Duration

Source: Bloomberg, J.P. Morgan, Orange Investment Advisors. As of 3/17/2023. Information shown are daily yield-to-maturity (YTM) and duration statistics for various sectors shown.
Blue bars represent structured credit sectors and gray bars represent traditional fixed income categories
CLO is represented by BBB CLO Index
RMBS Index is represented by CRT M1 OTR (rated A/BBB)
ABS is represented by Auto ABS Subordinate Composite Index
CMBS Index is represented by Conduit “A” rated 2014 vintage
Treasuries, Corporates, Agencies, Agency MBS and High Yield represented by the Bloomberg Indices

Figure 3: Capital Structure Resulting from Subordination

CAPITAL STRUCTURE RESULTING FROM SUBORDINATION
Senior Tranches	▪ Highest ratings; investment grade ▪ Last in capital structure to incur losses ▪ Receive principal payments first ▪ Lowest yield in capital structure
Mezzanine Tranches	▪ Subordinate to senior tranches ▪ Typically investment grade; can be slightly below ▪ Absorb losses only after junior tranches are written off ▪ Receive principal sequentially after seniors ▪ Yields between senior and junior tranches
Junior Tranches	▪ Subordinate to mezzanine tranches ▪ First in capital structure to incur losses ▪ Last in capital structure to receive principal ▪ Highest yield in capital structure

Evolution of Structured Credit

Since the global financial crisis, the structured credit market has undergone significant changes and enhancements. Numerous regulatory changes, including the Dodd-Frank Act and the Volker Rule within the United States and Basil III globally, have resulted in tighter lending standards, increased disclosure and reporting, greater risk retention by originators and increased capital requirements. These changes have led to increased oversight and protections for investors as well as reduced abuses by originators. Below are several key examples of types of credit enhancements and safeguards offered within structured credit.

Key Risks to Investing in Structured Credit

Every investment comes with risks. In fixed income, typical risks include interest rate risk, credit risk, liquidity risk and prepayment risk. Risks specific to structured credit include:

Interest rate risk: Rapid and dramatic shifts in interest rates may affect the value of a structured credit bond. Rate movements may also indirectly affect pre-payment or extension risk, which are essentially the risks of a callable bond being called sooner or later than projected by the investor.

Credit risk: Unlike an Agency bond that is backed by the U.S. Government, credit risk cannot be totally eliminated within non-agency structured credit, particularly in lower-rated, subordinate bonds.

Liquidity risk: Structured credit products may trade less frequently than other fixed-income products, making them somewhat less liquid. This is directly related to the fact that they are non-index, which is also the source of market inefficiency.  This risk can normally be effectively managed by experienced Structured Credit traders, but nonetheless will increase at times of heightened market volatility.

Complexity risk: While pooling multiple loans helps to diversify idiosyncratic credit risk, the Structured Credit market is complex and diverse, made up of a variety of deal structures and collateral types that require specialized expertise and resources.

The Case for Structured Credit in a Rising Interest Rate Environment

After suffering through one of the worst years in history amidst considerable fund outflows, bonds are expected to perform well given attractive yield profiles across most fixed income sectors. Given that we are likely to enter a recession by Q1 2024 and equity valuations are not currently attractive, we believe fixed income is an attractive asset class to consider adding to an investor’s portfolio.

The regime of steady, low interest rates is over, and interest rate volatility is likely to persist for the foreseeable future. The current volatile interest rate environment is yet another example of how difficult it is to predict and time interest rates. Therefore, a fixed income strategy that generates attractive returns without taking unnecessary interest rate risk may lead to higher quality returns.

Within fixed income, it is important to focus on strategies that maximize yield while minimizing duration to reduce interest rate risk while retaining income.  As highlighted in the chart above, structured credit is positioned to achieve these aims, with yields per unit of interest rate risk being the highest in almost 20 years. In particular, expected flows into fixed income will likely find their way to structured credit bonds, which are now offering 7-9% returns for investment grade cashflows with relatively low duration, something not seen in a generation.  We believe that, as demand materializes, particularly in the absence of new issue supply that is expected to be curtailed due to higher rates, spreads will mostly likely tighten resulting in capital appreciation on top of higher yields.

Going into a recession, fundamental credit risk may be harder to quantify in corporate credit sectors such as IG Corporates, High Yield and Levered Loans than in Structured credit sectors such as RMBS, CMBS, ABS and CLOs. This is because Structured credit bonds, which are securitizations of loans and other assets, feature certain structural advantages in the form of excess spread, senior/subordinate tranches, interest diversion mechanisms, over-collateralization and interest coverage tests, etc. which may provide investors with less credit risk.

Finally, within fixed income, structured credit sectors can offer higher risk-adjusted returns and opportunities for alpha because they are not indexed and are often priced more inefficiently than indexed traditional fixed income sectors. A bottom-up, active, value-based security selection strategy may help to capture these market inefficiencies and excess returns.

Conclusions: A Niche Where Expertise Matters

Overall, we see structured credit as an important piece of a properly diversified portfolio. By including exposure to structured credit within their diversified bond portfolios, investors can potentially increase their overall risk-adjusted yield while including an asset class with low correlations to other market sectors. And in a period of rising rates, structured credit’s risk/return profile can be even more attractive.

Because structured credit is a specialized part of the fixed income market, investors may benefit most from working with an experienced manager who can understand, identify and unlock the value that this may offer market offers.

To learn more about structured credit and how you could potentially enjoy its numerous potential benefits, contact us at info@easterlyfunds.com or call (888) 814-8180.

Glossary

Average Duration: Average duration is generated by Morningstar from the categories funds by weighting the effective duration of each fund’ portfolio by its relative size in the category.

Bloomberg Barclays U.S. Aggregate Index: A broad bond index covering most U.S. traded bonds and some foreign bonds traded in the U.S. The Index consists of approximately 17,000 bonds. 

Call Risk: Call risk is the risk that a bond issuer will redeem a callable bond prior to maturity. This means the bondholder will receive payment on the value of the bond and, in most cases, will be reinvesting in a less favorable environment—one with a lower interest rate.

Effective Duration: This measure of duration takes into account the fact that expected cash flows will fluctuate as interest rates change and is, therefore, a measure of risk. Effective duration can be estimated using modified duration if a bond with embedded options behaves like an option-free bond.

Structured Notes: Structured notes are debt obligations with an embedded derivative component. The value of the derivative is derived from an underlying asset or group of assets, such as a benchmark.

Yield per unit of duration: Is the funds yield to maturity divided by the fund’s duration.

Important Investment Risks

Structured credit notes are subject to call risk, a lack of liquidity, and inaccurate pricing due to limited activity in the market; the investor must be willing to undertake significant credit risk in the event the issuing investment bank forfeits its obligations.

A CLO is a trust typically collateralized by a pool of loans. A CBO is a trust which is often backed by a diversified pool of high risk, below investment grade fixed income securities. A CDO is a trust backed by other types of assets representing obligations of various parties. For CLOs, CBOs and other CDOs, the cash flows from the trust are split into two or more portions, called tranches. MBS and ABS have different risk characteristics than traditional debt securities.

Important Investment Risks

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