Home / Focus / Less-travelled paths to alpha in structured credit

For most of 2021, global credit investors have been basking in the goldilocks environment of accommodative Fed policy, generous fiscal stimulus, and a rather strong economic recovery, despite some COVID-19 bumps along the way. The strong performance of credit risk assets has elevated valuation levels.

 As the prospects of Federal Reserve tapering, higher inflation, peak economic recovery, and fiscal drag loom, investors need to enhance return and diversify portfolios via less-travelled paths in this more challenging environment.

The universe of structured credit is one market that offers unique, compelling relative value opportunities, and can be an attractive complement to traditional corporate bonds.

ASSESSING RELATIVE VALUE: CORPORATE CREDIT VERSUS STRUCTURED CREDIT

First, let us look at current valuation levels within credit risk assets.

ICE BAML U.S. BBB and High-Yield Corporate Credit Index option-adjusted spreads (OAS) are both at historical tights, irrespective of longer average durations and lower average credit ratings during the period. While valuations for structured credit are currently not cheap, some sub-sectors, including collateralized loan obligations (CLOs), conduit commercial mortgage-backed securities (CMBS), non-agency residential mortgage-backed securities (RMBS), and consumer asset-backed securities (ABS), offer higher yields relative to similarly rated corporate bonds with comparable duration.

Should credit investors add some allocations to structured credit for enhanced return potential and portfolio diversification? We look at three reasons why adding structured credit may enhance the efficient frontier for credit investors, adding the potential for alpha while diversifying risk. 

SUPPORTIVE FUNDAMENTALS

The case for allocating to structured credit starts with relatively attractive fundamentals. The red-hot housing market and healthy household balance sheets remain obvious tailwinds for RMBS and consumer ABS. Additionally, other factors may have a contrasting impact on corporate credit versus structured credit in the post COVID-19 world. The US corporate sector currently faces several potential headwinds challenging profitability, including supply chain disruptions, higher labour costs, rising corporate tax rates, and interruptions in the reopening of the economy.

Most of these headwinds may have relatively minor — or even positive— impacts on US structured credit investments, implying that structured credit can potentially provide diversification benefits. For instance, the supply chain disruptions that have been squeezing auto and homebuilder production and profits have actually boosted used vehicle and home prices to historical highs.

The rise in prices is naturally a positive for the collateral value of auto loans and mortgages, enhancing recovery values upon defaults. Auto ABS loss rates are currently at historical lows, driven by high recovery rates on repossessions. Supply chain disruptions and low manufacturer inventories also have raised prices of equipment and containers, benefiting the performance of ABSs backed by leases of those collaterals.

Furthermore, supply chain constraints and labour shortages in housing construction can be a headwind for homebuilder corporate bonds but a tailwind for RMBS because of higher housing prices due to lower housing supply. Additionally, household balance sheets have been rather healthy due to low interest rates and multiple rounds of wealth transfer from massive stimulus programs.  

Furthermore, wage inflation, which would usually be negative on the corporate side, may be positive for consumer ABS and RMBS as higher wages reduce consumer stress. The transition rate into serious delinquency for consumer loans and mortgage loans remained at historically low levels through 2020-2021. An improving labour market and higher wages should be tailwinds, helping contain default rates despite the ending of fiscal stimulus.

Despite the improving collateral performance and deal structure deleveraging, ratings agencies have yet to conduct rating upgrades.

We believe there is opportunity investing down in the capital stack in RMBS and consumer ABS, both because of the improving fundamentals and the potential for rating upgrades. Within the RMBS sector, we believe the credit risk transfer (CRT) market offers liquid exposure to the improving housing market. The non-investment-grade CRT tranches present ratings upgrade potential due to the fast deleveraging of deal structures. Among consumer ABS, we favour non-investment-grade tranches of subprime auto and marketplace lending also for their ratings upgrade upside.

VALUATIONS: GENEROUS COMPENSATION FOR THE RISK CMBS—the ultimate reopening story: Overall, COVID-19 hit commercial real estate hardest, resulting in distressed valuations and a lagging recovery. However, various sectors of the commercial real estate market present very different fundamental stories:

• Industrial and multi-family are performing very well, supported by respective tailwinds of faster growing e-commerce and rising housing prices.
• Hotels, a highly cyclical sector, are still in the recovery process and gaining good momentum.
• Within Retail, the accelerated secular decline of certain subsectors is not new information and is mostly priced-in.
• Offices face the most uncertainty as the return-to-office rate is still slow. However, the office sector is a bifurcated story of the “haves” and the “have-nots.” Newly built and higher-quality Class A office buildings are still in high demand; older and more commoditized Class B and Class C office buildings face a harder time attracting tenants.

 As a result of the above challenges, we believe CMBS bonds offer opportunity relative to corporate bonds, presenting investors attractive recovery and reopening investment opportunities. We see the BBB part of the capital structure standing out as a relative opportunity both against the AAA CMBS tranche and against high-yield BB corporate bonds.

CLO valuations are relatively attractive: We believe CLO AAAs, BBBs and BBs are currently cheaper than corporate investment-grade and high-yield, on a relative-value basis. CLOs look rather attractive given the potential for spread pick-up. Their floating-rate nature also serves as a good hedge against a rising interest rate environment.

The performance of CLOs through COVID-19 has been solid, with improving leveraged loan fundamentals exhibited in historical low default rates and low downgrade-to-upgrade ratios.

FAVORABLE MARKET TECHNICAL

Non-agency RMBS, consumer ABS, and CLOs are experiencing very limited or even negative net supply. Freddie Mac has tendered some seasoned CRT deals recently, prompting investors to look for replacement opportunities. Tight supply and strong demand create a favourable market technical environment, particularly compared to the corporate bond market’s record supply.

ASSESSING DIVERSIFICATION BENEFITS

The correlation between corporate credit and structured credit has varied during different time periods and market cycles due to relative market sizes, drivers of market volatility, composition of market participants, and other factors. There also have been time lags between corporate credit and structured credit, with the latter sometimes lagging the former in both market rallies and sell-offs. Due to those different dynamics, structured credits have provided diversification benefits relative to corporate bonds during past credit cycles.

Here are some examples:

• The early 2000s, characterized by the Enron and WorldCom scandals, were challenging for US corporate credit; however, ABS, RMBS, and CMBS performed well as house prices continued to appreciate amid a decent labour market.
• The energy crisis during 2015 and 2016 was another distressing period for corporate credit with defaults on energy names, but housing and commercial real estate were in a bull market, leading to solid performance across structured credit.
• The US-China trade war, combined with quantitative tightening by the Federal Reserve in 2018, challenged corporate credit performance. However, ABS, RMBS, and CMBS performed well because of solid household balance sheets, deleveraging, and better underwriting post-GFC. From the above, we can deduce that structured credit does provide potential diversification benefits. Incorporating both corporate and structured credits in the same credit portfolio should help expand the efficient frontier, enhancing return and reducing return volatility

CONCLUSION

Facing the challenges of peaking growth, rising inflation, richer asset valuations, and the withdrawal of monetary and fiscal stimulus, credit investors need to assess relative-value opportunities among various credit markets to seek returns.

One attractive area that warrants consideration, in our view, is structured credit, due to its good value, attractive total returns, and diversification benefits relative to corporate credit.

We favour down-the-capital-stack investment in CRT, consumer ABS, CMBS, and CLOs, as they are supported by improving fundamentals, cheaper valuations, and a favourable market technical.

Tracy Chen is portfolio manager at Brandywine Global, part of Franklin Templeton

 1 Data source: Source: FRED St. Louis Federal Reserve, ICE Data Indices, LLC 2 Source: BofA Global Research, ICE Data Indices LLC 3 Source: Manheim, S&P, Goldman Sachs Global Investment Research 4 Source: KBRA, Goldman Sachs Global Investment Research 5 Source: Macrobond 6 Source: New York Fed Consumer Credit Panel/Equifax 7 Source: BofA Global Research, ICE Data Indices LLC 8 Source: BofA Global Research, ICE Data Indices LLC 9 Source: ICE-BAML, Palmer Square, Goldman Sachs Global Investment Research 10 Source: S&P, LCD, Goldman Sachs Global Investment Research 11 Source: S&P, LCD, Goldman Sachs Global Investment Research 12 Source: JP Morgan Research Indexes are unmanaged, and one cannot invest directly in an index. They do not include fees, expenses or sales charges. Important data provider notices and terms available at www.franklintempletondatasources.com