In a world of prolonged low interest rates, institutional investors are scouring different pockets of the investment landscape to generate additional returns. One area is capital regulatory transactions, which are far from new but are being put under the microscope for their potential as part of an alternative credit portfolio. However, these transactions can be more complex than other alternative credit asset classes and require specialist expertise, skills and understanding.

  • Credit risk sharing first appeared about 20 years ago when they were linked to a bank’s internal calculations
  • More recently, the EU has highlighted securitisation as a means to boost lending as part of its Capital Markets Union agenda

In a world of prolonged low interest rates, institutional investors are scouring different pockets of the investment landscape to generate additional returns. One area is capital regulatory transactions, which are far from new but are being put under the microscope for their potential as part of an alternative credit portfolio. However, these transactions can be more complex than other alternative credit asset classes and require specialist expertise, skills and understanding.

For one thing, they go by different monikers. Technically they are labelled as balance-sheet synthetic securitisations, but many in pension circles label them as credit risk sharing (CRS) transactions while some call them credit risk transfers (CRT), significant risk transfer securitisations (SRT) or capital solution transactions (CST) to name a few. In essence, these expressions refer to banks transferring part of the credit risk of a portfolio of loans to investors. 

They first appeared on the scene about 20 years and were linked to a bank’s internal calculations, according to Milan Stupar, portfolio manager at AXA IM Alts, which has been operating the field for the same time frame. However, the asset class gained momentum after the global financial crisis as banks looked to release regulatory capital due to the more stringent Basel III regulatory capital requirements. 

The rules require banks to calculate regulatory prudential capital requirements using ‘through the cycle’ parameters, which assume that an economic downturn will occur during the life of all credit exposures held by banks. Additionally, it is necessary for banks to have a buffer for further unexpected events such as the COVID-19 crisis, although few would have predicted a pandemic in 2008.

James King, head of ABS portfolio management at M&G Investments, another established player in the field, explains that banks are allowed, in effect, to share the risk with investors and manage their regulatory capital on an ongoing basis. They can do so through whole-loan asset sales, full capital structure securitisation or synthetic securitisation. King says the benefit for the banks is freed capital that can be re-used, for example, for new loans to clients.

“They can be seen as an alternative investment to equities, and they have a better risk profile than, for example, high-yield bonds” - Mascha Canio

More recently, the EU highlighted securitisation as a means to boost lending as part of its Capital Markets Union agenda. In May 2020, the European Banking Authority (EBA) recommended the creation of a cross-sectoral ‘simple, transparent and standardised’ (STS) framework for balance-sheet synthetic securitisations. The new proposed rules follow the same principles as the 2018 guidelines, which looked to develop a single set of consistent interpretations of the existing standards.

“The EBA set out the criteria for these transactions because when the market first started it wasn’t clear what the criteria was,” says King. “The key, though, is that the market is growing up. People look at it differently, but we call them significant risk-transfer transactions and they fall under structured credit. They are illiquid, require a lot of upfront work, fundamental research, due diligence, technical knowledge and monitoring. You also need to have robust systems to ensure they are compliant with securitisation regulation.”

As a result, the barriers to entry have been high and it is not surprising that there are only a handful of players in the market. This explains why last year Swedish occupational pension manager Alecta joined forces with Dutch pension fund service provider PGGM to co-invest in what they call CRS. Their first transaction is a multi-year programme with JP Morgan that covers about $2.5bn (€2.1bn) of corporate loans. 

Partnerships of this kind between pension funds from different countries are still relatively rare, although PGGM is a leader in the field.

“CRS is a very niche area and there is only a small group of people who are involved,” says Tony Persson, head of fixed income and strategy at Alecta. “PGGM has been doing this since 2006 but the real trigger for banks was the global financial crisis and the tighter regulations. However, we are a small team, and these transactions are too complex for us to do in a cost-effective way, so we decided we needed some form or co-operation and a much more specialised team to handle them.”

He adds: “This has enabled us to take on credit risk which had not been accessible in the past. It has given us diversification and exposure to many different loans books, from SME lending to project finance, which in turn provides a way to lend to the real economy.”

Mascha Canio, head of credit and insurance-linked investment at PGGM, also says that investors gain exposure to illiquid and unique credit risk with different borrowers and lending products. “They can be seen as an alternative investment to equities, and they have a better risk profile than, for example, high-yield bonds. We have generated realised annual returns of around 11% since we started in 2006,” she says.

PGGM began by investing on behalf of its pension fund client PFZW. The mandate takes first and second-loss positions in mezzanine or junior tranches of selected loan portfolios in return for an agreed fee from the originating bank. It is important, though, that the bank has “skin in the game” and while regulation requires 5% of alignment of interest, PGGM requires the [risk] sharing bank to keep 20% unhedged loss exposure on its own balance sheet, according to Canio. 

PGGM also undertakes detailed due diligence as well as both quantitative and qualitative analysis, looking at the type of loans, contract terms, how the bank extends loans and manages risks. “We evaluate each transaction to see how they would perform in normal, slightly and very-stressed economic conditions,” says Canio. “We call these base cases, headwinds and stress scenarios and although we did not predict the pandemic, the analysis gives us a good indication whether it is a good investment through time or not.”

Canio also says the term ‘complicated’, which is often used to describe these transactions, may be misleading. “They are conceptually quite simple, in that an investor takes credit risk on a selected portfolio of loans from a bank up to a pre-agreed amount and in exchange gets a commensurate return in the form of coupon payments,” she says.

Stupar echoes these sentiments and adds that investing in a bank’s equity exposes investors to the whole bank as a risk, whereas with these transactions there is only the credit risk of well-defined portfolios.

“These transactions have dates of maturities, known coupons and final pay-offs based on realised losses,” he says. 

“One of the differences with AXA IM’s approach is that we totally underwrite the portfolio and select credits on a name-by-name basis. It is fully disclosed, compared to others who invest in a blind portfolio. We also believe that 5% of alignment is usually enough,” says Stupar.

Looking ahead, he sees increased demand for these credit risk transfer transactions. “It is a growing market in terms of size and number of banks interested,” he adds. “2019 was a record year with new issuance of above €10bn and last year was slightly below, despite the pandemic, although it was the second-best year for volumes. On the investor side, most of the real money will co-invest through funds, but we are seeing greater appetite not only from the larger but also smaller insurance and pension funds.”

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