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    Structured Insights: opportunity through adversity

    Structured Insights: opportunity through adversity

    March 26, 2020 Global macro, Structured insights, Fixed income

    At what we think is a critical juncture for all of us and for the financial markets, we would like to introduce Structured Insights, a monthly series on global structured credit markets.

    For institutional investors that are not overly liquidity-constrained, we believe high-quality (AAA) structured credit will likely offer a rare combination of defense, credit quality enhancement and spread pick-up over your existing corporate and structured bond portfolios. We observed that AAA spreads are ~3-6x wider than they were in February.1

    As the financial crisis moves from a liquidity crisis to a credit crisis, we believe an opportunity set will slowly start to unfold for opportunistic, stressed and distressed investors. More on this in the months to come.

    “Patience is not the ability to wait. Patience is to be calm no matter what happens, constantly take action to turn it to positive growth opportunities, and have faith to believe that it will all work out in the end while you are waiting.” – Roy T. Bennett

    In times of adversity, we often need to process huge amounts of information, whether financial, geopolitical or (as is the case today) epidemiological. These are also times when complexity can create uncertainty, then panic, and eventually a self-fulfilling crisis.

    This crisis feels unique from a human perspective, but each crisis has common-looking underlying financial roots and ultimate trajectories. As different as the catalysts may look to us today, the root causes of recent market moves are similar to past periods (such as the 2008 crisis, the euro debt crisis, post-9-11 market stress, the dotcom bubble and all the way back to the Great Depression).

    The investment opportunities arising inevitably from the embers of financial crises may well be unique, but they too tend to present themselves with a high degree of commonality suggesting a level of uniformity and simplicity that can help us navigate them.

    The Two-Act Financial Crisis

    The COVID-19 pandemic presents a global threat incomparable to anything since the Spanish flu of 1918. However, the financial market impact on valuations has been more familiar, and consistent with periods such as the 2008 crisis.

    The 2008 financial crisis unfolded in a two-act structure – a model which we anticipate the current crisis will also follow.

    Act 1: Liquidity crisis

    During financial crises, cash becomes king, driving liquidations. There is a financial element as investors need to make margin calls, meet client redemptions and manage performance. There is also a psychological component, given the drive to liquidate before being told to or ahead of others.

    Act 1 is well and truly underway, but the impact has been even worse this time. Banks are now less able to function as a conduit of risk transfer due to post-2008 era regulation. As a result, we have not needed a banking crisis to see banking crisis-era volatility.

    The result has been some of the sharpest daily equity declines since 1987 and the sharpest bear market in history.

    Notably, in fixed income, the most violent sell-offs have been in:

    1. The highest-rated bonds
    2. The shortest-dated bonds
    3. Off-the-run liquid bonds

    This has been because they are the easiest to offload to raise cash (or the least understood in the case of off-the-run bonds), even though they are fundamentally the safest and technically the most directly supported by monetary policy.

    Act 2: Credit crisis

    Global shutdowns on an unprecedented scale would create the dreaded self-fulfilling cycle of depressing economic activity, increasing uncertainty, lowering valuations, further reducing economic activity and so on, precipitating an inevitable credit crisis. The fiscal response may need to be significantly higher than the $2trn announced in the US (and ideally be globally coordinated) to completely prevent it.

    But, we are still in the very early stages of this. There remain large unknowns, such as how:

    • successful the global virus containment will be and how long it will take
    • the global economy responds to mass shutdowns
    • effective the fiscal and monetary responses will be
    • soon effective drugs or vaccines will arrive

    This makes pricing credit risk incredibly difficult. It can be dangerous to rely on the ‘accepted truths’ that underpin many top-down financial models.

    As such, we believe that through Act 2 there are two principles that matter most:

    1. Appreciate what we don’t know – and avoid top-down analysis if we can’t know enough
    2. Focus on bottom-up credit appraisals – there will always be winners and losers to find amid indiscriminate or forced selling

    These principles indicate to us that it is too soon to focus on capturing credit risk-related opportunities. The time will come, but we feel we need to be patient and, for now, focus on opportunities from Act 1.

    Global high-quality structured credit is a potential ‘Act 1 opportunity’

    The last month has been particularly sobering for the highly-rated liquid instruments that are designed to be resilient against precisely this type of environment.

    However, liquidity (and not credit) issues have led to sell-offs in long-dated Treasuries, high-grade corporate bonds, gold and the AAA-rated global structured credit markets.

    High-grade structured credit markets now essentially price in a reverse ‘liquidity premium’ (which is, perversely, a premium for being easier to sell). Spread levels are, in many cases, three to six times higher than they were just a few weeks ago (Figure 1).

    Figure 1: Evolution of AAA structured credit spreads (bp)2

    Category (AAA) Sector

    (February 29, 2020)

    Consumer Secured and Unsecured RMBS UK 50 300
    RMBS US (Non QM) 95 400
    RMBS AU 150 300
    Cards US 5 400
    Student Loan ABS 100 600
    Unsecured Consumer US 100 600
    Prime Auto US 50 300
    Subprime Auto US 80 500
    Commercial LCF CMBS 75 300
    CRE CLO 100 400
    SFR US 80 300
    CMBS EU 100 300
    Corporate-backed CLO EU 80 400
    CLO US 130 500
    MM CLO 180 500

    We are confident that this is a liquidity story rather than a credit story because we believe AAA structured credit is often structured to largely withstand:

    • Severe credit deterioration (consistent with default probabilities of 1bp over 10 years)3
    • Entire loan pools defaulting4
    • ~60% falls in real estate markets (assuming all mortgages have already defaulted)5
    • Close to the entire underlying CLO asset portfolio defaulting at conservative recovery rate assumptions6

    Additionally, many senior structured credit tranches can potentially benefit from a rising default environment due to acceleration (Figure 2).

    Figure 2: European CLO AAA bought at 90 cash price (bp)7

    Scenario Targeted return Targeted life
    Expected base case 400 4 years
    100% default case 1000 1 years

    Given these realities, at today’s levels we believe this is a very interesting opportunity set on a fundamental long term value basis for those that are not liquidity-constrained. Specifically, we feel it is attractive to those worried about the uncertainty of credit risk pricing (as we are).

    Incredible care is of course required, however. Some areas (such as aircraft ABS or junior CLOs) have been on the frontline of the crisis. Bottom-up credit analysis is required to ensure you are targeting the liquidity premium (from Act 1), rather than uncertain credit exposure (from Act 2).

    High-grade structured credit may offer defense as well as value

    With a highly uncertain and unprecedented global economic backdrop, we believe that high-quality structured credit can potentially offer a measure of comfort and certainty in these testing times. It can offer diversification against unsecured corporate credit exposure, credit quality and structural protection as well as spread.

    We anticipate that building a diversified, dedicated AAA multi-sector structured credit strategy today has the potential to yield ~300bp above Libor. This compares to a month ago, when a BBB/BB strategy would yield ~250bp to 300bp above Libor based on our observations.8

    As we continue to navigate this period of disruption, we should strive to maximize the certainty of our investment outcomes.


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