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    Structured Insights: extend your portfolio in 2022

    Structured Insights: extend your portfolio in 2022

    February 28, 2022 Structured credit

    As structured credit markets continue to evolve, insurance companies are extending their investment strategies into alternative, emerging and private structured credit investments.

    We highlight four areas of strategic interest to in-house investment teams and also preview our broad asset class outlook. Our approach at Insight remains customizing rated investment grade portfolios to extend our clients' strategies across these markets.

    Summary


    Four ideas for extending structured credit investment strategies

    1) Consider real estate 2.0 structured product

    The legacy RMBS market is shrinking by ~20% per year. Although this is a positive feature, investors need to consider additional ways to gain exposure to the housing market. Many new products can serve this purpose, such as agency credit risk transfer (GSE CRT), mortgage insurance credit risk transfers (MI CRT), mortgage servicing rights ABS (MSR), non-qualifying mortgage (QM) RMBS, rated re-performing loans (RPL) and single-family rental (SFR) ABS.

    We also believe CMBS investors should consider commercial real estate (CRE) CLOs. The latter have outperformed the former since the start of the pandemic. The special servicing rate on CRE CLOs peaked at ~2% compared with ~10% for traditional CMBS deals1. We believe this reflects issuers’ skin-in-the-game, given they retain the bottom ~15%-18% of the capital stack. New issue volumes also overtook Conduit CMBS (~$45bn vs ~32bn), with several individual deals over $1bn. We expect this trend to continue given rising demand for transitional loans. For insurers with appetite for floating rate product, CRE CLOs also offer appeal in a rising rate environment.

    2) Broaden your BSL CLO portfolio into the middle-market

    Many insurers maintain exposure to broadly syndicated loan (BSL) CLOs, but in our experience, too few have additional exposure to middle-market (MM) CLOs. The latter typically offer higher spreads and better credit enhancement across the capital structure. The tradeoff is in liquidity (given the relatively niche nature of MM CLOs) and typically less portfolio granularity and lower underlying collateral ratings.

    3) Extend your ABS strategy into esoterics

    Insurance companies increasingly allocated to esoteric structured credit in 2021 and we anticipate that this trend will only accelerate. We saw a pickup in financing unsecured consumer pools and private rated structures, taking advantage of trends in the market away from traditional bank lenders/lending products towards non-bank/marketplace lending platforms. Private financing and structuring of ABS product is also available across a wide range of collateral pools, with the potential for customized terms; investor protections; and illiquidity and complexity premia (see: Structured Insights: The esoteric market map).

    4) Look at non-US structured credit markets

    Many insurance companies avoid non-dollar structured product risk due to regulatory and FX accounting challenges. Many investment managers avoid these sectors due to lack of local market expertise and time zone challenges. For investors with the appetite to consider global ABS markets, stronger relative value pricing and more robust investor protections may be the reward. We like public and private ABS across the UK residential and consumer ABS markets, Australian residential mortgages as well as European CLO. Global relative value and illiquidity pricing models are important to operate flexibly across geographies and product formats.

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    Core market outlook

    RMBS

    The two current key themes are home price appreciation and rising interest rates driving slower prepayments.

    The former has been beneficial for sectors such as Agency CRT, MI CRT and Non-QM which are already generally exposed to higher LTV collateral. Similarly, single-family rental transactions have benefited from both rising rental rates and higher property valuations.

    We believe the negative impact of rising rates can be mitigated through floating rate sub-sectors such as Agency and MI CRT and even more so by mortgage servicing rights-backed transactions that actually exhibit rising collateral values with slower prepayments.

    Further, the increased granularity of risk-based capital factors under the proposed NAIC regime might also open up opportunities in the capital stack where, in our view, the strongest relative value resides in sectors like Non-QM and rated re-performing loans.

    Consumer ABS

    The US consumer market looks well positioned to outperform in 2022, as it did in 2021, although rising interest rates will introduce greater spread volatility.

    The unemployment rate is back near pre-pandemic lows with wage growth at double-digits in the leisure sector, and other indicators indicative of a tight labor market. Savings rates as a percentage of disposable income is well above the pre-pandemic trend.

    However, as unprecedented fiscal support fades, we expect consumer credit delinquency and loss levels to moderate from unsustainably low levels. As such, while we expect subordinate consumer positions to outperform, investors should monitor any changes to the non-prime unsecured consumer sector as an early indicator of any deterioration.

    ABS supply hit $312.6bn in 2021 and is likely to moderate as we head further into 2022. After an anemic 2020, there was a high degree of “catch-up”, particularly given the favorable interest rate environment. As the Federal Reserve moves towards monetary tightening in 2022, the overall demand for credit and hence ABS issuance will likely decline. As such, we anticipate lower excess spread levels as issuers will struggle to pass along rate rises to the end borrower.

    Further, we expect collateral values to be supported as a measure of supply chain constraints continue in 2022, offering structured credit investors greater underlying protection.

    CMBS

    We see the best value in short-dated floating rate bonds and believe investors should consider migrating down to single As and BBBs where we believe fundamental improvement outpaces technical headwinds

    Commercial real estate fundamentals enjoyed a sharp, but uneven, recovery with industrial and multifamily sectors outperforming and retail turning the corner, while lodging and office still faces uncertainty. We expect these trends to continue into 2022 but at a slower pace, with at least greater clarity around the lodging and office sector, distinguishing the “haves” from the ”have-nots”.

    Therefore, we expect to see disparate performance within and across geographies and property types. We believe investors should shift from focusing on capturing beta to alpha by assessing which sub-sectors, markets and properties will benefit the most from durable pandemic trends after a new normal emerges.

    We expect to see some volatility, with the market torn between rebounding fundamentals and a negative technicals (including valuations, rising real yields, and monetary tightening). Hence our view on short-dated floating rate bonds and preference for A and BBB tranches.

    In our view, keeping powder dry, careful security selection, and compelling carry combined with sufficient credit support, will serve to mitigate risks in the search for alpha.

    Broadly-syndicated loan (BSL) CLOs

    We see US CLOs as benefitting from continued tailwinds and solid fundamentals in 2022. Tailwinds include:

    • continued economic strength, supported by the consumer
    • healthy corporate balance sheets with ample liquidity remaining, extending a benign credit and default outlook
    • absence of any significant corporate debt “maturity wall” in the near to medium term

    On the defensive side, diversification of leveraged loan portfolios and active credit management helps mitigate idiosyncratic credit risks, given potential for further supply chain issues and inflated input costs. CLO structures also showed resilience through the pandemic and prior credit downturns.

    Despite record global CLO issuance in 2021, and heavy supply in pipeline and forecasts for 2022, the sector continues to be supported by strong demand and a growing CLO investor base.

    CLOs also benefit from floating rates, and we believe the sector looks attractive on a relative value and risk-adjusted basis. Heavy supply has kept spread tightening somewhat in check, and carry looks compelling to us.

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    Alternative market outlook

    Non-US and middle-market CLOs

    For insurers with the investment and operating models to support non-dollar investing, we believe euro CLOs offer compelling relative value over the US BSL market, particularly in the mezzanine tranche of the capital stack, especially when factoring the value of embedded 0% euribor floors that are included in the vast majority of deals.

    Further, our European credit outlook continues to be favorable as policy stimulus and economic recovery continues, and relative value looks supportive of euro CLO spreads versus alternatives.

    Closer to home, US “middle-market” (MM) CLOs represent a niche segment of ~10-15% of the market where loans are backed by loans to smaller-mid-sized companies, typically originated, underwritten and held by a single direct lender or a small club of lenders.

    Although MM CLOs tend to be less liquid than BSL CLOs, with a smaller investor base and fewer active dealers, liquidity has improved over time. Into 2022 US middle-market CLOs continue to be one of our top picks for insurance and pension accounts that can tolerate lower liquidity in a portion of their portfolios.

    Middle-market CLOs offer some of the widest spreads in US structured product markets at each rating level, which helps compensate for lower liquidity.

    European RMBS / ABS

    We favor mezzanine tranches as we expect to see spread compression between seniors and mezzanine deals as investors move down the capital structure in search of yield.

    In our view, any weakness in collateral pools should not cause concern in investment grade mezzanine deals.

    In terms of sectors, we prefer consumer-backed collateral pools. UK non-conforming and buy-to-let, in our view, offer compelling relative value and yield pickup versus equivalently-rated Dutch RMBS.

    Last year was a record for issuance since the 2008 crisis, with another solid year in the cards as current spread levels look attractive to issuers (particularly in senior tranches). Further, as governments roll back funding policies from banks, it is incentivizing them to source liquidity from capital markets.

    Consequently, we expect to see increased issuance from bank originators in UK Prime RMBS in particular, as well as increased diversity in asset classes, examples including re-performing mortgages, non-performing loan securitizations and commercial real estate CLOs. We also expect growth in the number of non-bank consumer lenders who actively use capital markets as a long-term funding source.

    In 2021, collateral pools performed well even as pandemic-related fiscal support was gradually withdrawn given the strong economic recovery and abundance of central bank liquidity. We expect fundamental metrics to continue to stabilize or improve for both consumers and corporates into 2022. As such, we expect default rates to rise slightly as monetary policy is reversed but remain within attractive levels

    European CMBS

    We are focused on property types that have yet to fully retrace their pandemic drawdowns and new sectors (e.g., highway service areas) that can provide stable rental income but fall outside traditional real estate categorizations.

    We expect spreads, especially at the bottom of the capital structure, to have room to tighten as uncertainty around the pandemic wanes and the fundamental outlook for commercial property improves.

    2021 was the highest for primary volumes since 2013, a trend we expect to carry over into 2022. Diversity increased in terms of sponsors, property types and jurisdictions.

    In some select deals, pricing in seniors was the tightest seen since 2008, but restricted to property types that were least impacted by the pandemic (such as logistics and multifamily). However, in general, secondary credit spreads continue to be wider than pre-pandemic levels across most sectors.

    Australian RMBS

    We expect a continuing flattening of the credit curve as the Australian economy continues its path to normalization, so we favor mezzanine tranches in securitizations.

    After a volatile 2020, the Australian RMBS market had a strong rebound in 2021, with record volumes and margins on some tranches touching pre-2008 tights. Funding conditions overall have been favorable with tight issuance margins across the capital structure, a lack of capital market issuance, ongoing regulatory support for COVID-impacted borrowers and a robust lending and property market that have supported underlying asset values.

    In 2021, the bulk of issuance was originated by the non-bank sector. We expect this theme to continue with new entrants to the market attracted by healthy credit spreads and excess borrowing demand from consumers as the major Australian banks continue to reduce their lending footprint.

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    Esoteric market outlook

    We see particular value in the aircraft and unsecured consumer sectors. In general, we expect continued growth and innovation within esoterics, with new asset types such as media royalty transactions potentially set to hit the market in the near future.

    Esoteric ABS is coming off a strong 2021 for both issuance volume and spread performance. In general, esoteric deals have outperformed more mainstream areas of structured credit. Demand, driven by the quest of yield, resulted in illiquidity premiums compressing considerably.

    Investors demonstrated a growing acceptance of newer asset types, including those more closely related to the new economy, such as digital infrastructure, royalties on intellectual property, unsecured consumer fintech and renewable energy production assets. All of these asset types saw multiple transactions, growing in line with more traditional asset types such as whole business and oil and gas receivables.

    The sector continues to demonstrate some of the widest spreads available in the broader structured credit market. We attribute this to a combination of complexity on new asset types as well as lower liquidity due to smaller issuance volumes.

    We expect spreads will tighten again and thus offer the potential for value over the year ahead. We expect aircraft and consumer unsecured to benefit the most from further reopening and economic expansion while areas like media royalty and digital infrastructure are likely to see heightened performance because of further secular adoption.

    Areas such as oil and gas receivables may offer specific one-off opportunities based upon extraction type, proximity to final consumer and structure but will remain constrained by ESG concerns around fossil fuel exposure.

    Further, sectors more linked to the crossover corporate market, such as whole business and recurring revenue deals, may come under more pressure as corporate yields widen in sympathy with rising rates.

    Geographically, these opportunities should prove equally available across the developed markets and may see even greater growth outside of the US, where some of these asset types, such as data centers, have already become increasingly accepted.

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    Conclusion: cast the net wider

    In our view, structured credit continues to offer an outsized premium over comparably-rated corporate credit, considering the strong fundamental performance and the fact the transactions are structured to withstand unprecedented macroeconomic shocks and underlying loan pool defaults.

    Nonetheless, we are at the precipice of economic regime change, with central banks under increasing pressure to raise policy rates, while credit spreads trade around historically low levels and the premium from moving down the capital stack has also compressed over the last year.

    As such, we believe there will be winners and losers. In our view, the best way to navigate the environment is to ensure the largest menu of options. The latitude to focus on the most attractive issuers across the core, alternative and esoteric markets, while focusing on combinations of asset types and global regions offers the greatest potential to manage uncertainty.

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