Structured Credit: Alphabet soup: a second helping

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Joseph Mariathasan takes a look at the structured credit and loans markets and finds a surprising abundance of reasons to tuck back into the alphabet soup, even after significant spread-tightening

Finding reasons to invest in structured and securitised credit in the first half of 2009, when one of the great value opportunities of all time presented itself, was one thing. Finding reasons to hang on to this paper now that spreads have come back in again is another
“We like the diversification benefits produced by the underlying assets in structured and securitised products,” declares Christopher Redmond, a senior investment consultant at Towers Watson. “We are seeing flows across the board into structured products,” says Laurent Gueunier, head of structured finance at Axa Investment Managers.

Redmond sees two key attributes that can justify allocations. First, whereas the dominant return driver for investment grade corporate bonds is currently the government bond yield (and hence long-duration), structured products are predominantly floating-rate assets.

Second, they give exposure to very different businesses and activities. The issuers in the European secured loan market, for example, are predominantly owned by private equity firms, and asset-backed securities (ABS) provide direct exposure to the end consumer in the form of mortgage payments and credit card receivables.

Leveraged loans can be accessed directly or through collateralised loan oblications (CLOs). The typical three-tranche structure of a CLO is analogous to that of an ABS: the senior tranche has the most credit and structural support and a AAA or AA rating; the mezzanine tranche is supported by the equity part of the capital structure with ratings between A and BB; and finally the (unrated) equity tranches take the first-loss portion of the capital structure and receives interest only after all the other tranches are paid. However, unlike in the ABS market, the models and ratings used in CLOs continued to work as expected right through the financial crash, according to Martin Horne, a managing director at Babson Capital Europe.

He observes that the strength of the CLO structure was that the credit performance of the underlying collateral - syndicated bank loans - was both predictable and transparent, with greater visibility into portfolio and less complexity and modelling risk.  There was also a robust collateral performance history with bank loan default and recovery performance dating back to 1992 and comparative analysis through high yield bond default and recovery performance dating back to 1970.

The default and recovery rates were consistent with previous recessions and have quickly returned to pre-crisis levels while secondary market liquidity allowed for normal market operation and price discovery. Babson has found no cases of senior cash flow CLOs incurring even $1 of principal loss, and it finds most junior tranches now trading between 70-85 cents on the dollar and over 80% of equity tranches delivering cash flows. Ratings agencies are currently upgrading CLO tranches - but while AAA tranches used to have spreads of 20bp, they are now up around 150bp.

While the underlying loans are non-investment grade, the prospects of recovery in the event of a default are much higher than for high-yield bonds - long-term recovery rates are around 80%, according to Horne. The equity stub typically starts repaying 4-5% per quarter, so the capital can be returned within 4-5 years, giving a low to mid-teens IRR. The crisis caused a spike in default rates, leading to losses for investors in the equity tranches, but now they are back to a mode of repayment. Moreover, a number of amendments have extended loan terms and raised coupons.

“A private equity sponsor has a three-year horizon and may see a business as sound but not the return horizon, so it will extend the loan to 5-6 years,” explains Horne. “As investors, we can get 100% of our investment back on the original due date and in several cases, we have decided not to extend.”

Babson also sees the CLO structure as having features that promote performance and ratings stability not present in other structured products: there is appropriate subordination for each tranche and efficient structural enhancements; and matched funding - in that both collateral and tranches are floating-rate (particularly attractive in the current environment of concern about rising longer-term rates). The collateralised bond obligation (CBO) market vanished following the 2004 corporate crises. As AXA IM’s head of structured credit investment Alexandre Martin-Min recalls: “This was not because of bad credits, but because there was a problem with having fixed rate assets with floating rate liabilities. Trading in CBOs was very inefficient.”

Nonetheless, one key unresolved debate around CLOs is over the extent of risk retention required by the collateral manager. In the US, the Dodd-Frank Act of July 2010 aims to ensure that ABS markets in general require an element of risk be retained by issuers. However, while the act was aimed primarily at mortgage backed securities (MBS), its knock-on effect might stunt the CLO market’s growth.

In Europe, the primary market for loans is still very weak. As Jonathan Butler, managing director and head of Pramerica’s European leveraged finance business points out, new issuance of loans in Europe has largely dried up. “In the US, there is an arbitrage between the liabilities and the assets of CLOs that drives their issuance,” he says. “There is a liquid leveraged loan market and debt investors are prepared to accept lower spreads, enabling issuance. Issuance is spread fairly evenly between LBOs and sub-investment grade corporates. In Europe, by contrast, issuance has been almost exclusively by LBOs and that loan market has collapsed. Asset prices have gone up but limited debt investor appetite has left spreads wide on the liabilities.”

The figures are quite stark: Butler quotes a figure of €111bn of European institutional tranche leveraged loans issued in 2007, but just €13bn for 2010. In the US, while issuance has gone down from the 2007 figure of $426bn, it was still a healthy $207bn in 2010 (after virtually no new issuance in 2008-09).

“Today, there are not many buyers of AAA tranches in Europe - just the occasional treasury of a big bank,” Axa IM’s Martin-Min concurs. “The equity tranches are bought by non-regulated investors such as family offices, pension funds and prop desks.”

There have been a few CLOs in Europe and Axa IM itself intends to launch one shortly. “For a long period of time, the underlying loans were very cheap, but it was very difficult to put in the financing for a CLO,” explains Martin-Min. “There were not enough active buyers of the AAA tranches, although there was some interest for the equity stubs. Now the marketplace is more balanced with investors in the US and Japan, in particular, for AAA tranches as well as some equity investors. Today, the market wants simple structures with not too many tranches and without highly discounted assets. Our structure would have only performing European loans from 60-80 different issuers.”

Butler sees some portfolios of loans becoming available from banks and Pramerica itself invested in balance sheet CLOs issued by Barclays and Citigroup. However, he is not keen on the European marketplace: “We are seeing some increased interest, but for European CLOs we cannot suggest that the equity stubs offer attractive returns to investors, so we are not willing to do a European deal.” Instead, he argues that European investors should be looking to invest in global portfolios, which inevitably means a high proportion in the US: “Europeans like to invest in the European market where they gain comfort from the currency, but we have to educate them. The European products are more expensive and lower quality.”

Towers Watson is focused on two key risks and post-crisis changes to the market when it comes to secured loans and CLOs. First, there has been a material shift in the investor base for secured loans. CLO funds were the dominant investor pre-crisis, but they are becoming, and might remain, less significant as their assets mature and new issuance remains muted. So far pension funds and retail investors have stepped in via investments in unleveraged loan funds, but Towers Watson believes there is still a void to be filled and a lot of work left to do to educate them on the market’s complexities, but also its relative attractions versus alternatives.

The second key risk is the oft-discussed ‘wall of refinancing’ that is due to peak in 2014, when around $200bn of loans mature. These fears first arose when it became very challenging to refinance in the first half of 2009, but conditions have changed dramatically since then. “Thanks to quantitative easing and access to credit, we see the wall of refinancing disappearing,” says Martin-Min. “It happened quicker in the US but is now happening in Europe.” Redmond notes that the calendar year maturity profile that gave rise to the ‘wall’ analogy is now more of a slightly steep hill. Nonetheless he still worries: “If there is a circumstantial event leading to a shut down in the capital markets at an inopportune moment, then there will be an issue.”

In Europe, loans have been refinanced in the high-yield bond market, which has doubled in value over the past two years. There were 26 inaugural high-yield issuers in 2010 and there were already 21 for 2011 by April, according to Simon Finch, credit CIO at London-based hedge fund CQS. But there are implications for the distressed cycle: deals in the high yield market are increasingly of lower quality with single B or lower-rated deals up from 32% of new issue volume in 2009 to 44% in 2011. Moreover, if a company cannot finance or refinance in the current very open market environment - and there is a substantial tail of such companies - it could be much harder as we head into a potentially more discerning market as we approach 2014.

Turning to ABS, we find what Shammi Malik, managing director of ABS and covered bond trading at Cantor Fitzgerald Europe, calls “a declining asset class in Europe”.  Redemptions are still higher than new issuance. And yet there has been a rally in the market since mid-2010, which Malik attributes to a kick-start by hedge funds dropping their ‘buy later, buy cheaper’ strategy and the desire of traders to build up inventories. “Virtually all asset classes are currently trading at record tight spreads across the capital structure,” he observes. “Dealers do not seem to care, even if they are paying above the fundamental value.”

AAA spreads are sub-200bp compared with 600-700bp a year ago. With the weighted average cost of liabilities having fallen so dramatically, all of a sudden the economics makes sense to permit new CMBS issuance. Malik describes this as “unthinkable only six months ago”. Thus, not only is the European ABS market being tested with its first CMBS issue (via DECO-CSPK) but also with Spanish auto loan receivable issues via Volkswagen Finance (Driver España One) and a successfully placed UK non-conforming RMBS issue.

Clearly, there is a huge amount of money waiting to invest in these asset classes via the primary market. In May there were a number of new issues and, as Henderson Global Investors argues in a recent note, the broadening of the market beyond UK and Dutch prime residential MBS and German auto loans is a sign of improving health.

But the ABS market has been overshadowed in the past couple of years by the covered bond market, where €150bn has been openly marketed and placed by the end of May 2011 compared with €100bn of ABS (which includes retained issues). Malik sees the target for 2011 as a whole as €250-275bn for covered bonds versus €150bn for ABS.

“From a regulatory and risk/return viewpoint, covered bonds tick all the right boxes,” he says. “Politicians have killed off the ABS market and blamed it for the financial crisis. Banks cannot include ABS holdings towards their short or long-term regulatory liquidity ratio calculations while covered bonds are allowed. So, from a Basel III viewpoint, covered bonds are preferable to ABS. For insurance companies the proposed Solvency II regime also favours covered bonds.”

Structured products, despite the flaws in the design of ABS that came so dramatically to the fore during the financial crisis, have the key strengths of enhanced yield and diversification from traditional credit exposures. But their complexity creates issues that still spook institutional investors.

Depending on clients’ risk profile and goals, Towers Watson sees its pension fund clients investing anywhere up to 30% of their non-government bond portfolios in a combination of secured loans, high yield bonds and ABS. But it avoids CLOs in general: “Complexity is a big thing for us,” says Redmond. “Only at particular times are investors paid for taking on the complexity associated with a CLO investment. The current opportunities abound for specialist loan and alternative credit managers to add value in unleveraged funds through bottom-up stock and sector selection, with opportunistic, off-benchmark investments in CLOs providing a small, additional source of added value.”

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