19 November 2020
By: Michael Meyer, CFA, VP, Illiquid & Real Asset Strategist, Mortgage & Structured Finance
Gregory Ward, VP, Product Manager, Mortgage and Structured Finance
With fixed income sector yields at historically low levels, insurers are feeling pressure to achieve their income objectives. In our view, pockets of the securitized market have been overlooked and may help fill this need by providing compelling yield potential and relative value.
This would broaden insurers' traditional focus on high-quality securitized credit within their investment grade fixed-income reserve portfolios. The following article discusses the broader opportunity set that can be found in the structured credit universe (see Sidebar: Solvency II Considerations).
Structured Credit Universe
Globally, the public portion of the structured credit universe is approximately $15.2 trillion – split evenly between US Agency issues and securitized credits (asset-backed securities, commercial and residential mortgage-backed securities, and other types)1. Private opportunities represent trillions more. Structured credit plays an integral role in today's economy, enabling issuers to finance business operations to support a broad swath of the economy (including auto loans, aircraft leasing, equipment leasing, residential and commercial mortgages and credit card receivables).
The structured credit universe is frequently exposed to real assets. These assets can include real estate, autos, equipment (e.g., aircraft, containers, rail cars) and infrastructure. Such assets tend to produce recurring contractual cash flows and provide tangible collateral. They can also provide diversification from other types of financial assets and a potential hedge against inflation.
The 2020 Market Year-to-Date
Like most asset classes so far in 2020, structured credit has experienced volatility. As the pandemic brought economic activity almost to a halt in March, many investors rushed to sell assets to raise cash, significantly straining the markets. Corporate spreads were the first to widen. However, a liquidity crunch in securitized assets rapidly drove prices down as investors sought to liquidate assets that had not yet followed corporates wider. As asset prices fell, forced deleveraging by certain market participants (e.g., mortgage REITS) exacerbated the sell-off. Observing the financial markets' challenges, the Federal Reserve (Fed) stepped in to provide support in late March. Sparked by the Fed's actions and fiscal stimulus, sentiment quickly changed and markets generally rebounded sharply in the second and third quarters.
Due to a relative lack of direct support from the Fed, the recovery in securitized assets has not been equivalent across all sectors and has generally lagged the rebound in corporate credit. For example, travel-related sectors (hotels, lodging, and aviation) have struggled, while consumer-related sectors have benefited from the US government's fiscal stimulus during the spring and summer. The uneven recovery and the potential for year-end volatility could create opportunities for attractive yields in specific structured credit sectors and classes of securities.
Recognizing Opportunities Across Risk Tranches
Through the securitization structure's tranching of risk, investors are able to identify and invest at the risk level they are most comfortable with while having the opportunity to earn a potentially attractive rate of return. Investing in structured credit also enables investors to diversify away from traditional corporate exposures into areas like consumer credit and real estate.
The tranching of risk creates a large investable universe for insurance companies seeking investment-grade exposure. Below-investment-grade credit represents only 5% to 10% of the securitization market. Frequently, higher-rated tranches represent a significant proportion of the deal structures with limited availability of subordinated tranches. As an example, a recent prime auto deal's AAA-rated tranche represented approximately 96% of the deal structure and the remaining tranches were rated AA, A and BBB. Similarly, a new subprime auto deal consisted of a AAA tranche (63% of the deal structure) with the remainder of the notes split amongst AA (9%), A (11%), BBB (9%), BB (4%) and B (4%) rated tranches. We acknowledge that obtaining an allocation to the subordinated tranches (AA+ to BBB-) can be challenging due to their limited supply. However, investing in less liquid, privately sourced structured credit, backed by real assets, can help achieve insurance companies' targeted allocations.
Accessing Securitized Markets
The securitized bond market is complex and fragmented with approximately 40 times more CUSIPs than that of the U.S. corporate bond market. Barriers to investor participation are high. From an issuance perspective, government-sponsored entities, other regulated institutions and independent finance companies are reliant on the securitization market to finance their operations. In our view, these factors can contribute to securitized spreads being wider than comparably-rated corporate securities.
Understanding the macro environment and what is happening within specific sectors are key components to any investment decision. Investors must be aware that owning securitized credit is a structurally leveraged bet on underlying fundamentals. Additionally, structural leverage can create downgrade risk and binary investment outcomes, particularly in relatively thin classes deep in the capital structure. Analytical sophistication and experience are required in this market. Investors must have scale and relationships with issuers, the sell-side, advisors, and others to originate, analyze, and monitor investments.
While the Solvency II implementation in 2016 resulted in punitive charges for securitized assets, the European Insurance and Occupational Pensions Authority (EIOPA) most recently in January 2019 revised the Solvency II rules. This gave a boost to the securitization market with the STS (simple, transparent, standardized) framework and the reduced solvency capital requirement charges related to senior and non-senior STS securitizations. We continue to monitor the EIOPA rules and look for ways to utilize securitizations for clients subject to Solvency II in capital efficient ways.
We believe that insurers would benefit from broadening their approach to the structured credit market. The combination of illiquidity and structural premiums that can be found in this market can create effective sources of incremental yield to support the overall business of the insurance enterprise.
This paper is provided for informational purposes only and should not be construed as investment advice. Opinions or forecasts contained herein reflect the subjective judgments and assumptions of the author only and do not necessarily reflect the views of Loomis, Sayles & Company, L.P. Other industry analysts and investment personnel may have different views and opinions. Investment recommendations may be inconsistent with these opinions. There is no assurance that developments will transpire as forecasted, and actual results will be different. Data and analysis does not represent the actual or expected future performance of any investment product. We believe the information, including that obtained from outside sources, to be correct, but we cannot guarantee its accuracy. The information is subject to change at any time without notice.
Market conditions are extremely fluid and change frequently.
Diversification does not ensure a profit or guarantee against a loss.