Unhedged Commentary: Why Investors Should Bet on Structured Credit

January 22, 2014  

By Brian Walsh

   
   

It is easy to understand why investors are flocking to equities, despite the fact that most liquid assets today are looking relatively expensive. Equities clearly have momentum behind them, and the path of least resistance is higher. For example, since 1870 there have been 30 times that the annual stock return exceeded 25 percent, and in 23 of the following years stocks were up an average of 12 percent, according to BCA Research. In addition investors are generally not fully allocated to stocks, and there is a definite pattern of catching up or chasing returns. Equity mutual fund flows were positive this year for the first time since the financial crisis.

From a more fundamental perspective, however, the picture is more challenging. Consider the following, which may temper enthusiasm for stocks: Since the market bottom in March 2009, the S&P 500 is up 170 percent; never before has the market gone up that much without at least one 20 percent correction. Earnings multiples are at their post 2008 high. If at the beginning of 2013, a genie had told you earnings by the end of year would be close to 70 percent less than forecasted and that bond yields would rise approximately 1 percent, you probably would not have predicted a 30 percent rise in stocks. Furthermore, while record profit margins continued to expand last year, at some point profit margins have to revert to the mean, or the basic rules of capitalism need to be rewritten.

For these reasons, the amount of risk investors may be taking on by investing in equities and credit-sensitive fixed income products may not justify the returns these products generate. But one asset class that does offer an attractive risk/reward profile is structured credit. Structured credit generated great returns in 2012 and 2013 (15 percent to 20 percent-plus), and it continues to provide interesting opportunities. The yields available in certain structured credit bonds are less than they were 18 months ago, but on an absolute and relative basis, the asset class is more appealing than most.

There are three main reasons why structured credit remains attractive. First, there still is a stigma attached to these bonds — structured credit was the toxic waste of 2008, and many traditional investors continue to avoid it. Second, structured credit is more complex and opaque, and many bonds have uncertain duration. These features make them less attractive to traditional fixed income investors.

Third, new banking regulations are especially targeted at structured credit; capital rules mean that less market-making capital will be devoted to more complex and generally less liquid segments of the market such as structured credit. These regulations impede a bank’s participation in the sector, which means enhanced opportunities for pools of private capital, like hedge funds. The overall result is a sector with less competition, where investors with the tools to analyze and research these complex and opaque bonds can capture "information arbitrage"-style incremental yield. This combination of less competition with greater complexity translates into genuine opportunities to generate excess return, as well as significant price disparities of bonds with similar risk profiles.

The best opportunities today are in both legacy paper and new issue securitizations. In the legacy paper, opportunities exist in a variety of sectors, including non-agency residential mortgage-backed securities, whole loan non-performing residential mortgages, student loans, trust preferred securities, commercial real estate collateralized debt obligations and commercial mortgage-backed securities. The yields achievable vary but in many cases approach 10 percent, with high probability of no principal loss (from the purchase price). There can be mark to market losses, of course, but based on underlying collateral and subordination in bond structures, bond prices have good safety margins.

In addition, within the U.S., RMBS investors can buy interest-only strips, which increase in value when rates are rising, thus providing a hedge to rising rates. Certain assets yield in excess of 10 percent with a similar margin of safety, but these assets are much less liquid and require a longer holding period.

Lastly, the opportunity set in Europe is good and growing as European banks decrease their financial leverage and exit sectors of the market. For example, total bank assets relative to gross domestic product is greater than 300 percent in the Eurozone, versus 90 percent in the US, and it is generally recognized that U.S. banks have been much more active in shedding assets. Still, even in the U.S., the top 100 banks hold $150 billion of non-performing and $80 billion of re-performing residential whole loans respectively. Overall, this should continue to create a steady pipeline of opportunities, both in the U.S. and abroad.

The opportunities for new issue securitizations are focused on non-conventional residential mortgages and more esoteric market segments. These opportunities involve taking leverage and first loss exposure, but the excess interest and the amount of equity underlying the collateral significantly mitigate the risks involved. In these cases, equity-like returns are available without as much downside exposure associated with equities.

The main risk in the sector is liquidity. This assumes you are investing with someone who has the capabilities to do the required research and analysis on the bonds both in terms of the underlying collateral and the structure on the bond securitization. The other side of liquidity risk is of course increased return, as the best opportunities are in the more illiquid sectors of the market.

Brian Walsh is chairman and chief investment officer of Saguenay Strathmore Capital.


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