On July 8 we have held our Diversified Structured Credit Pool webinar 'Transforming risks into opportunities'. During the webinar Remko van der Erf, Co-Head Alternative Strategies at Kempen Capital Management and Pieter Laan, Manager Selection at IBS Capital Allies talked about the benefits of investing in this asset class and our approach in managing it.
How to position structured credit in a broader portfolio context?
Structured credit provides some great advantages in the current climate, but how exactly should investors position it into their portfolios?
We believe that structured credit could act as an excellent complement to, or substitute for, other liquid credit investments, such as investment-grade and high-yield credit, leveraged loans and emerging-market debt.
If you’re investing high up the structured credit capital structure it could be a good substitute for investment-grade credit, while if you’re investing lower down it could replace high-yield or emerging debt.
What about liquidity? Senior asset-backed securities (ABS) are relatively liquid, roughly on a par with investment-grade credit, but lower down the capital structure it is less liquid, and funds concentrating on this area might have monthly or quarterly liquidity.
However, structured credit should not be seen as a replacement for highly illiquid forms of fixed income, such as private debt, infrastructure debt and real estate debt, which typically involve investment horizons of five years or longer.
For investors who are concerned about interest-rate risk, an allocation to structured credit could significantly reduce the interest-rate sensitivity of their overall portfolio. With most developed-market rates near zero at present, structured credit looks attractive as an increase in rates would actually benefit the asset class. That’s because structured credit instruments generally have floating rates or very low duration, and the only part of the market with significant interest-rate sensitivity is commercial mortgage-backed securities (MBS).
Finally, because the structured credit market consists of so many different categories and lots of different tranches within each, we think there’s more scope for specialist managers with the right platform and skillsets to generate alpha than there is in more traditional segments of the bond
In short, relative to traditional credit investments, structured credit provides a spread pick-up as compensation for its marginally lower liquidity, higher level of complexity and increased mark-to-market risk in the kinds of market conditions we observed in March this year.
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Structured credit: a compelling prospect relative to other fixed-income classes
Structured credit sold off sharply in March's severe market turbulence, as did almost all other risky assets. In fact, it sold off more than would have been expected based on its credit ratings. But rather than representing fundamental problems with the asset class, this was in large part due to technical factors.
Most important among these was that there was a huge wave of forced selling among investors that had run asset-liability mismatches. These were primarily US daily-liquidity fixed-income mutual funds that typically invest a portion of their assets in structured credit for the yield that it provides. Mortgage Real Estate Investment Trust (REITs) were also forced to sell.
This led to massive outflows from the asset class, most notably in a highly unusual trading session in the weekend of 21-22 March. But to us, this development was a very strong buying signal. And this is exactly how it has turned out: since the second half of April, the asset class has rebounded strongly.
Is it too late to take part in the rebound? Depending on the area involved, around 60–80% of the spread widening that took place in March has been recouped. That means that while bond prices could still appreciate from levels around 85-90 cents (i.e. the pull-to-par) an allocation to structured credit is now more about the spread pickup and the diversification benefits that it provides.
In our view, structured credit still looks attractive relative to other classes of fixed income. It's possible to produce a well-diversified structured credit portfolio consisting of several asset types with an average BBB credit quality trading at around 85–90 cents – which means it can still trade up to par value – and providing a yield of up to 6.5%. By contrast, most other kinds of fixed income are already trading above par and providing a much less attractive yield.
Of course structured credit could fall in value again if a second wave of coronavirus hits or the economic outlook worsens, but we believe it's better placed to weather such circumstances than other forms of fixed income.
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An attractive proposition thanks to the strength of the consumer
The coronavirus crisis has caused a huge spike in debt as governments across the world have taken on huge fiscal deficits and companies have issued vast amounts of new bonds to raise funds to keep afloat.
But this increase in debt hasn’t been across the board: overall, individual consumer debt levels have actually been falling. That’s because people have been using the money that they have received direct from governments as part of furlough schemes and that they would otherwise have spent on holidays, restaurants or petrol to pay off their mortgages or other loans.
We believe that an allocation to structured credit, which encompasses a range of securities backed by various types of loans and mortgages (many of which are linked to consumers), could be a good way to capitalise on this situation. Thanks to its exposure to private individuals it’s a great way of diversifying an existing bond allocation, and it’s also providing an attractive yield pick-up relative to traditional bonds issued by governments or companies at present.
And encouragingly for the asset class, consumers are holding up well, particularly in the US. Back in March, it wasn’t clear how long people would be able to pay back their mortgages or auto loans, and investors feared the worst. But it hasn’t panned out that way. While the figures are of course worse than they were before coronavirus, they’re not as bad as some had expected nor as market pricing in March suggested. For example, while 15%1 of people with the highest-quality mortgages had been expected to take up the option to take a mortgage-payment holiday, only 6%2 have done so and this figure is already plateauing.
Of course the question remains what will happen when government fiscal programmes end. But with this being an election year in the US, the current administration has an incentive to keep the consumer happy so various forms of stimulus might go on for some time.
Although the future is uncertain and no asset class is without risk, we believe the transfer of money from governments to individuals we’ve seen makes structured credit look an attractive option.
- Fannie Mae https://www.fanniemae.com/portal/media/speeches/2020/financial-results-q12020-remarks.html
- Mortgage Bankers Association https://www.mba.org/2020-press-releases/june/share-of-mortgage-loans-in-forbearance-decreases-for-first-time-in-series-to-848
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Kempen Capital Management N.V. (KCM) is licensed as a manager of various UCITS and AIFs and authorised to provide investment services and as such is subject to supervision by the Netherlands Authority for the Financial Markets.
This document is for information purposes only and provides insufficient information for an investment decision. This document does not contain investment advice, no investment recommendation, no research, or an invitation to buy or sell any financial instruments, and should not be interpreted as such. The opinions expressed in this document are our opinions and views as of such date only. These may be subject to change at any given time, without prior notice.