Where to from here? We think it could be time for institutional investors to set out in a new direction...
Expanding structured credit horizons
Our regular readers will be familiar with the structured credit market map we use to help navigate relative value opportunities and portfolio construction strategies for clients (Figure 1).
Figure 1: The global structured credit universe1
Many US institutional investors, including insurance companies and corporate treasurers, root their structured credit asset allocations firmly in ‘core’ product. Given core markets are the deepest, most liquid and vanilla markets, this is perhaps not surprising. Shifting capital into more credit intensive sectors and more complex structures requires access to dedicated resources and expertise.
What the past has shown us, however, is that there may be great rewards for those willing to expand their horizons. This may be particularly the case over the near term as, while structured credit has in general recovered well following the initial shock from the impact of COVID-19, this recovery has been strongest in the most liquid on-the-run sectors. Flexibility to move across sectors, to go private and to finance more esoteric collateral types will, we believe, help institutional investors mitigate the historic compression in credit spreads and continue to outperform.
Figure 2: Structured credit versus corporate bonds2
Looking ahead, this means we generally see the least value in core markets, particularly the most crowded senior debt, but see value in off-the-run areas that are gaining wider acceptance. Alternative markets have generally lagged the rally in core structured credit and, in our view, offer relative value. We believe certain segments of the esoteric market offer the greatest potential to outperform.
Table 1: Snapshot of relative value3
|Spread to US IG Corporates||+25bp||+25bp to +50bp||+75bp to +150bp|
|Widest spread to Libor (last 12 months)||+200bp||+350bp||+600bp|
Core market outlook
Delinquency and forbearance metrics continue to improve. Homeowners have generally held firm against economic headwinds – helped by fiscal and monetary support (the latter heavily spurring refinancings). The strong housing market has been an even more important fundamental factor – offering borrowers and servicers flexibility in mitigating losses even amid default.
As a result, most forms of agency and non-agency securitized credit are fundamentally well-positioned. RMBS spreads have generally moved in lockstep with fundamentals and have tightened inside of pre-COVID levels. Therefore, more on-the-run residential sub-sectors like agency CRT and prime jumbo likely have little room to tighten.
We see more value in peripheral sub-sectors such as Non-QM (which did not exist before 2008), mortgage insurance CRT and mortgage servicing rights transactions have the potential to outperform as growing acceptance across platforms results in improving liquidity.
US ABS markets ended 2020 on a strong note – and we see few catalysts that would cause spreads to re-cheapen.
Fundamentally – consumer ABS markets directly benefited from extraordinary fiscal and monetary policies and the political will is potentially now in place to pass further consumer-friendly spending policies if needed. As the pandemic first hit, capital structures were initially enhanced, but have now mostly reverted to pre-COVID norms.
Technicals are also supportive. Supply was down ~20% last year and is particularly constrained in the credit card and unsecured consumer sectors as well as other, largely off-the-run, sectors. We have seen new issues oversubscribed as much as 30 times, particularly across subordinate tranches as the grab for yield continues.
In our view, on-the-run sectors such as prime auto and bank credit cards currently offer little more than carry. We do, however, see greater value in less ‘core’ consumer areas, such as private student loan and unsecured consumer markets as the credit curve continues to flatten.
The pandemic has disrupted all US CRE property types, greatly accelerating secular trends and much of the effect may be long-lasting. On the positive side, however, the decline in valuations has been relatively benign, thanks to a large volume of global dry powder seeking compelling income-producing assets.
In 2021, we expect a K-shaped economy. We expect the ‘losers’ (such as hospitality and retail) to continue to struggle and the ‘winners’ (such as industrials, data centers, life science offices and single-family rental) to benefit. Some sectors (like multifamily) fall somewhere ‘in between’ with both forbearance relief and eviction moratoriums set to expire, while the longer-term trend for offices will depend on the evolution of remote working.
Investor demand is particularly robust at the senior part of the capital structure, leaving little value on the table. Given greater idiosyncratic risk lower in the capital structure (mostly tied to property type concentration and sponsor quality) we see the optimal risk/reward balance in the middle of the capital stack.
Alternative market outlook
BSL, Middle-Market and non-US CLOs
The CLO market has largely lagged the recovery enjoyed by corporate credit and many other structured credit sectors. Although US BSL CLOs are trading inside or on par with pre-COVID levels across the CLO capital stack (albeit tiering remains across managers and deal metrics), the sector still looks cheap to alternatives in our view, which is supporting technicals.
However, the market generally expects supply to pick up in 2021 (~$110bn new issue) and current spread levels have kickstarted a CLO refi/reset wave; while CLO “refinancings” or “resets” do not represent net new issuance, they can cause fatigue in market demand especially when the new issue calendar is also relatively busy. On balance though, we still believe technicals will remain a net positive. Fundamentals also continue to improve. Corporate loan default rate expectations have declined, as most companies have been able to find the liquidity they need to ride out the uncertainty.
For those that can invest in European CLOs (and hedge currency risk), the euro CLO market offers compelling relative value over the US market, especially when factoring in the 0% Euribor floor benefit that the bulk of deals have.
Also, for those able to tolerate slightly less liquidity, US middle market CLOs continue to offer significantly higher spreads and higher credit enhancement across the capital stack versus US BSL CLOs (which in our view overcompensates for the lower liquidity). Spreads in this (more niche) sector have not yet recovered to pre-COVID levels and the underlying collateral performance continues to be relatively strong. As always, we do stress that CLO manager selection here is key.
For more on CLOs, including middle-market and non-US deals, see our white paper: A Fresh Look at the CLO Market.
The European ABS and RMBS markets were relatively stable in 2020, providing a source of ballast. We believe the outlook points to continued low-volatility income and spread compression.
The market’s strong fundamentals were robust through the crisis. Delinquencies and default rates in both ABS and RMBS did not materially change, with the stress much less than expected. The market only experienced material weakness during the unprecedented liquidity squeeze. Another year of net negative supply is also expected this year. Nonetheless, outside of AAA deals, spreads are still generally wider than they were pre-COVID levels and are at multi-year wides compared to equivalent-rated corporate credit.
Looking ahead, we expect the downward trend in delinquencies and defaults to continue. There are certain sectors that will take longer to repair, such as SME and consumer unsecured, but they comprise a very small segment of the market.
Outside of retail (where we believe the downturn still has a way to go), the fundamental outlook has improved since Q2 last year. European CMBS spreads have only retraced only about half the spread widening we saw during 2020, lagging core ABS sectors significantly, offering potential relative value and room for spreads to ‘catch up’.
The Australian consumer has benefited from government support and the nation’s relative success in supressing COVID-19. Senior Aussie RMBS spreads are back to pre-COVID levels, but mezzanine tranches have yet to retrace all the widening. As such, we think they offer potential relative value versus equivalent RMBS tranches in Europe. While we expect arrears to rise over the coming year, we think government fiscal support to the consumer and conservative leverage levels on the underlying mortgages will help minimise any adverse impact to the RMBS bondholders.
Esoteric market outlook
Given the wide range of estoeric deal-types, fundamentals for esoterics are all over the map and cannot be easily categorized.
At one extreme, whole business deals (which tend to be heavy in franchise fast food takeout chains) are seeing exceptional sales performance as ‘dining in’ has dwindled.
At the other extreme, aircraft securitizations and rental car fleet deals have suffered given the lack of business and leisure travel. Nonetheless, even among the hardest hit sub-sectors, the prospect for defaults and significant losses appears to be waning.
From a spread perspective, esoteric deals have exhibited some of the strongest outperformance of any structured credit segment. On the heels of supportive central bank actions from earlier in 2020, illiquidity premia has compressed markedly. We expect this to continue, particularly as the Federal Reserve appears reluctant to respond too hawkishly on the monetary front and as Congress debates another sizeable fiscal stimulus.
Opportunities in the esoteric sector stand out and remain high on our radar for outperformance over 2021.
Conclusion: flexibility is key
The past twelve months have been extraordinary in many ways, both from personal as well as economic perspectives. Risk markets collapsed when the pandemic resulted in economic shutdown but almost as breath-taking was the subsequent recovery in valuations as both fiscal and monetary policy provided the safety net, limiting the material deterioration in the fundamental performance of credit instruments.
As we sit here in 2021, this unprecedented provision of liquidity has seen a remarkable rise in equity markets and a dramatic reduction in credit spreads – which are now as tight as they have ever been for most of the market, creating real day-to-day challenges for investors. The good news is that we have been here before and, while we cannot ever pretend to defy gravity, we can look to the broadest areas of the structured credit market in our mission to extract higher returns without increasing the credit risks that we take.
‘Broadest’ in this context can and does have many meanings. We can look towards the Core, Alternative or Esoteric markets as we have already highlighted for example. We can also look globally for risk and take advantage of the material differences in regulatory environment and the subsequent impact that has on the spreads on offer to investors. We can also, of course, stay closer to home but move from the public towards the “grey” or private markets.
In our view, a broad and flexible relative value framework, allowing institutional investors to move away from the conventional, in a thoughtful way, will best serve investors in the low spread environment we expect to be in over the course of 2021. Or to end with a reprise of Thomas Wolfe: "You can’t go back home … to the old forms and systems of things which once seemed everlasting but which are changing all the time – back home to the escapes of Time and Memory".