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    Structured Insights: global health check

    Structured Insights: global health check

    June 16, 2020 Global macro, Structured insights, Fixed income
    Structured credit is weathering record unemployment across the globe, but the withdrawal of government safety nets will be the next big challenge.

    The first Structured Insights article outlined the two-act financial crisis structure (Act 1: the liquidity crisis and Act 2: the credit crisis). We are now in the intermission.

    Global health check 

    Our Act 1 strategy1 has performed well and we have begun to broaden it to include a subset of assets from our Act 2 strategy2. We are, however, yet to fully commit to certain Act 2 sectors and prefer, largely, to be more senior in the capital structure with greater margins of safety as we get more information and see our triggers for a wider investment hit.

    As we begin a measured rotation, this note provides a global health check and observations on various structured credit asset classes.

    How far have we come?

    Risk assets have recovered in recent weeks with certain US equity indices even setting all-time highs. Credit spreads across many markets, while not necessarily fully pricing a V-shaped recovery, now imply not much more than a mild contraction.

    In some ways the rally is not surprising. Certain data, particularly surrounding the American consumer, has been encouraging. The recent payrolls report beat expectations by a truly astonishing 10 million – equivalent to the entire workforce of New York state.

    But, in in other ways the rally is surprising. The US unemployment rate is, of course, still at post-Great Depression highs at ~13% and the future evolution of the pandemic remains unknown.

    Ultimately, the fiscal response (already equivalent, in the US, to the entire WW2 spending effort), which includes higher unemployment insurance and mortgage holidays, has supported credit fundamentals – for now.

    How far do we have to go?

    We surveyed our structured credit team for a global sector health check and update on how each major US and global sector is progressing.

    Patrick Wacker

    US Consumer ABS Patrick Wacker, Portfolio Manager

    Consumer ABS sectors have performed well since the onset of COVID-19. Borrower performance, particularly in higher-quality pools, has so far held up in line with a modest slowdown and nothing more extreme.

    Modification rates have also improved since April and are certainly lower than we normally would expect at extreme unemployment levels (at 5% across prime auto loans and 10-15% across non-prime auto loans, private student loans and unsecured consumer loans3).

    However, once the new unemployment benefits expire at the end of July, we expect delinquencies and defaults to rise, so have remained up the capital stack in most deals and have only invested in mezzanine tranches that we view as the highest quality of transactions.

    Richard Talmadge

    US RMBS Richard Talmadge, Senior Analyst

    Fundamental performance, having initially deteriorated in April and May, has recently stabilized or at least seen a slowdown in deterioration.

    Forbearance levels appear to have capped out around ~8.5% for fully-documented prime mortgage loans (both agency and non-agency) and ~33% for non-QM mortgage loans4. Delinquencies are creeping up, however, as a higher percentage of those who chose forbearance in April or May are now not making their mortgage payments. Through May, 30+ day delinquencies in prime loans increased to ~2% to ~4% while non-qualifying mortgage delinquencies were ~12% to ~14%5.

    Still, we expect delinquencies to improve as states open up. Some of the low-hanging fruit in areas like M2 CRT and senior non-QM tranches have been squeezed out. We still see value in non-performing and re-performing deals as well as mezzanine classes of non-QM and SFR transactions.

    Jeremy Deacon

    UK RMBS Jeremy Deacon, Senior Portfolio Manager

    In the UK, mortgage payment holidays have been introduced and are currently scheduled to last until the end of October. Approximately 20-25% of UK mortgage borrowers have taken this option and that figure appears to be peaking6.

    Additionally, the UK Government’s furlough scheme effectively pays 80% of the salaries of 11m people. As such, performance metrics of UK mortgages have been solid.

    We will be closely watching the tapering of the furlough scheme from August, and the end of mortgage forbearance soon after. A clearer picture of the credit impact will then emerge and, as such, we have chosen to remain in AAA/AA rated tranches and in higher-quality markets, such as prime mortgages.

    Tristian Teoh

    Australian RMBS Tristian Teoh, Senior Portfolio Manager

    Arrears and forbearance rose after March, but then forbearance reduced to a trickle after the April peak and the trend is expected to continue as the economy reopens. Senior spreads currently trade wider than equivalent UK deals, offering potential relative value.

    We continue to believe investors should approach sub-investment grade tranches with caution until greater clarity emerges on where unemployment will settle after the maturity of various government support schemes.

    Melissa Niu

    US CMBS Melissa Niu, Senior Analyst

    The impact of the pandemic will likely be longer lasting on US CMBS. Hotel RevPAR (revenue per available room) growth stands at -65% year-on-year and over a dozen major national retailers have filed for bankruptcy7. The CMBS delinquency rate tripled to 7.15% in May8. With the elevated level of loans in grace period or under forbearance relief discussions, risks of further imminent defaults and downgrades is elevated.

    We currently prefer conservative, senior tranches and transactions with extremely low exposure to exposed sectors such as hospitality and retail.

    Jason Cameron

    Global CLOs Jason Cameron, Senior Portfolio Manager

    Technicals have been strong, driven by risk-on sentiment and falling supply (which is down ~50% in the US and ~35% in Europe year-to-date9).

    However, fundamentals are still deteriorating. Rating agencies have been active in downgrading loans affected by COVID-19. The trailing 12-month default rates by principal amount for US and European loans markets through May were 3.1% (from 1.8%) and 1.43% (from 0.44%) respectively from end-February10.

    A relatively large portion of US BSL CLO BBBs and below-rated tranches are now been placed on negative watch. 23% of US BSL CLOs are now failing at least one overcollateralization test11. This diverts cashflows from junior notes to help protect senior notes (a self-protecting mechanism).

    We remain cautious, largely sticking to AA and better-rated tranches where the credit enhancement and structural protections provide a very significant buffer to the uncertainty that remains around the fundamental picture. At the margin, we find the spread pickup available in MM CLO tranches attractive, but are more cautious on US BSL CLOs versus EUR CLOs.

    Waiting for greater clarity

    Shaheer Guirguis

    Shaheer Guirguis, Head of Structured Credit

    There is considerable overlap across the major sectors globally. Performance has weakened, but not as much as expected given the levels of unemployment and consumer weakness we are currently seeing.

    As we wait for greater clarity and the expiration of the security net that has been provided, we are constructing portfolios that allow us to deliver the rates of return that were consistent with a BBB/BB average credit quality pre-COVID, but in much safer senior tranches that typically benefit from the greatest levels of security. We continue to believe this approach offers the highest risk-reward at this point in the cycle.

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