By Jenna Wilson, CFA, CAIA
The Global Financial Crisis gave structured credit a bad name. As a result of 2008, many investors believe the broader asset class contains unnecessary complexity and risk to warrant much attention. It’s true, subprime mortgages in mortgage-backed securities (MBS) and certain collateralized debt obligations (CDOs) led to extreme losses at the time, and while these structures grabbed the headlines, other structured products were resilient and performed well. For example, collateralized loan obligations (CLOs), which are backed by pools of secured bank loans to businesses, performed largely in-line with expectations through the trough and the ensuing recovery, in spite of the short-term mark-to-market volatility. There were certain investors that added excessive leverage on these securities and suffered from the resulting liquidity mismatch, but the actual products remained intact. Furthermore, since then, the CLO market has seen further structural improvements to protect investors and satisfy regulators, including higher levels of subordination, more rigorous collateral eligibility requirements, shorter non-call periods, and shorter reinvestment periods. We believe these actions improved the quality of the investible universe for structured credit today and find the return potential more compelling than buying individual loans or loan funds for long-term investors.
Leveraged loans are senior loans made to businesses with below investment grade ratings, often used to finance a private equity buy-out, acquisitions and funding for general growth opportunities. These loans are typically secured by the assets and cash flows of the business and have priority in recovery in a bankruptcy scenario. Investors who purchase loans outright are subject to idiosyncratic credit risk and compete against both institutional and retail buyers. CLOs, however, are purchased primarily by institutional investors and can offer higher returns for the equivalent or better credit quality as long as the investor has a long-term investment horizon. How is this possible? A CLO consists of a pool of hundreds of leveraged loans diversified across a broad range of industries and borrowers. CLOs are “securitized”, meaning borrowers can invest at different risk and return thresholds on this pool of assets. Insurance and pension funds may look towards the top of the securitization stack to maximize principal protection, but give up on returns. While junior tranches, typically purchased by investment managers (such as hedge funds and private equity firms), require greater credit underwriting but can deliver double-digit returns. This tranching of risk and return in CLOs allows for an opportunity to acquire better credit quality and enhanced return asymmetry versus owning the loans outright, but the trade-off being that lighter trading activity can create periods of pricing volatility. CLOs have historically generated higher returns with wider spreads compared to traditional debt instruments due to the institutional orientation, regulatory requirements and illiquidity. This complexity creates an appealing risk/return profile, especially in periods of dislocation.
That brings us to March 2020. The unexpected closing of the economy as a result of COVID-19 caused a sharp and sudden decline across all asset classes. There was a tremendous liquidity squeeze as investors went into risk-off mode, selling out of assets to raise cash, with no regard for their fundamental value. The S&P 500 was down over 12% in March with a standard deviation 3x the typical monthly volatility. High quality securities were not immune to this effect. Municipal bonds, as an example, ended the month down nearly 4%, notwithstanding the dramatic intra-month swing. Leveraged loans had a similar path as equities also declined approximately 12%. In comparison, CLO investment grade rated notes dropped about 5% while high yield tranches dropped over 20%. This was partially driven by heightened concerns for credit losses, but a more powerful driver was general fear and a need for liquidity, causing sellers to transact at large discounts in order to raise cash quickly.
The precipitous drop in prices, due to indiscriminate selling, has resulted in an exciting investment opportunity in structured credit, specifically for those with patient capital. If you hesitated in March, you may have missed the rebound in liquid markets which experienced one of the quickest recoveries on record supported by the government’s unprecedented stimulus package and various programs implemented by the Fed. As an example, leveraged loans have recovered most of the losses from the decline and are nearly flat on the year through October. On the contrary, the recovery in structured credit has been gradual, particularly in junior tranches. CLO equities have steadily climbed higher, only regaining about half of their pre-COVID values, and thus still affords an attractive opportunity for the next several quarters. We believe that the universe will continue to reprice higher as the market gains more certainty around an economic recovery. While we anticipate higher default risk compared to recent years, we believe returns generated from structured credit more than compensate investors for this risk as current yields today are much more attractive to pre-COVID levels. We believe there is additional upside based on current marks in comparison to fair value and relative to other asset classes.
Sources: J.P. Morgan, DoubleLine, S&P Global, Bloomberg; As of 10/31/2020
At Simon Quick, we are active allocators to the structured credit opportunity. We have aligned ourselves with managers displaying rigorous credit underwriting standards, conservative use of leverage, and a history of avoiding permanent losses. While these managers and funds suffered from selling pressure in March, these funds were unlevered and, in many cases, carrying a cash balance. Margin calls or redemptions did not force their hand. We’ve focused on smaller managers that can be nimble and react quickly to pockets of opportunity. They were able to play offense and be proactive buyers during a period characterized by significant mispricings.
In April, we began increasing our exposure to this asset class with the understanding that this opportunity will take a healthy dose of patience. We believe an allocation to structured credit, in particular those collateralized by corporate borrowers, represents a very attractive multi-year opportunity. With all that being said, it is crucial to enlist a best-in-class investor with the expertise to navigate the inefficiencies in the market including the geographical, collateral and manager dispersion.
If you would like to discuss this opportunity further, please reach out to your Client Advisor at Simon Quick.
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