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          Structured Insights: intermission and roadmap for Act 2

          Structured Insights: intermission and roadmap for Act 2

          May 20, 2020 Global macro, Structured insights, Fixed income
          “If you can’t fly, then run. If you can’t run, then walk. If you can’t walk, then crawl, but by all means keep moving.” – Martin Luther King Jr.

          Welcome to our second monthly note on global structured credit markets. The first Structured Insights outlined our view on the two acts of the COVID-19 financial crisis (Act 1: The Liquidity Crisis and Act 2: The Credit Crisis)1.

          We concluded that our optimal structured credit strategy today focuses on extracting the ‘reverse’ liquidity premium, but not yet the credit risk premium. We call this the Act 1 Strategy and have since invested this way for our clients by targeting high-quality portfolios. We believe a more credit-orientated Act 2 Strategy will become appropriate in due course.

          Intermission: preparing to crawl

          We have since continued to see COVID-19 exert its cost on humanity through a merciless rise in infection cases and, tragically, deaths. We have also seen it govern our lives both through the inhibition of freedoms and also economic toil, resulting in the steepest rise in unemployment since the Great Depression. It remains too early to know what shape a recovery will take.

          We have also seen the most extraordinary response from governments around the world in the face of these challenges. They have ranged from wartime-like mobilization of medical equipment production to far-ranging protections for those facing the toughest economic burdens. We have also seen central banks pump liquidity into the system and explicitly provide support for asset prices through initiatives such as the Fed’s TALF program.

          These conditions exert two powerful, but opposing forces on investors – economic devastation and policy response. As to which will prevail, we can currently only speculate. But, we can provide a road map for structured credit investing – we can, still, keep moving.

          Before we highlight the roadmap, we’ll catch up with the performance of the Act 1 strategy to set the stage for where we go from here.

          Performance of the Act 1 Strategy

          The Act 1 Strategy is comprised of assets we consider credit risk-remote (even given current economic circumstances). As such, we believed they were always likely to recover first given how attractive valuations had become following the liquidity squeeze (and subsequent rush to sell these assets in March). The recovery subsequently occurred in April. Figure 1 demonstrates how the target spreads of each asset class have changed over the period, given changes in market pricing.

          Figure 1: High quality ‘Act 1’ structured credit assets performed strongly in April, resulting in a tightening of our target spreads2

          Category (AAA) Sector
          (AAA)

          Target spread over Libor
          (end-March 2020)

          Target spread over Libor
          (end-April 2020)
          Consumer Secured and Unsecured RMBS UK 300 120
          RMBS US (Non QM) 400 250
          RMBS AUS 300 200
          Cards US 400 100
          Student Loan ABS 600 300
          Unsecured Consumer US 600 300
          Prime Auto US 300 125
          Subprime Auto US 500 250
          Commercial LCF CMBS 300 200
          CRE CLO 400 300
          SFR US 300 225
          CMBS EU 300 300
          Corporate-backed CLO EU 400 200
          CLO US 500 200
          MM CLO 500 350

          We still continue to believe the strategy is highly attractive. The spreads and the structural protections on offer still, in our view, can provide compelling compensation amid the substantial uncertainty we face. The Act 1 Strategy still has an average AA rating which yields, on average, more than equivalent BBB or BB structured credit assets offered pre-COVID-19.

          We do, however, think it’s time to evolve part of the strategy in recognition of the extraordinary central bank and government support, which has resulted in some of our assets moving closer to fair value than others.

          We want to rotate away from the assets close to fair value, but under a disciplined framework. This leads us to our roadmap.

          Gradual transition to Act 2: beginning to crawl

          As we evolve our strategy, we look for three necessary conditions:

          1. Collateralizaton: we target sectors and transactions where, through the collateral of the underlying loans or the over-collateralization of the structure, we feel we have enough security against even the weakest of economic recoveries
          2. Central bank or government support: central banks have provided extraordinary stimulus which has put a potential floor on asset prices in many areas. But even more importantly, in our assessment, has been the fiscal support which has dramatically improved the security net of small businesses and the furloughed/unemployed. Deals that benefit most from these actions are more likely to make it into our strategy
          3. Spread: we look for expected returns that, we believe, still offer an outsized reward for the risks.

          Figure 2: Three essential conditions for evolving our strategy3

          Case Study4: We used the above framework to conclude that now may be a good time to consider adding to seasoned credit risk transfer (CRT) instruments. These are RMBS transactions issued in 2016 and 2017 by government-sponsored entities in the US that benefit from the following:

          1. Collateralization: average LTVs of underlying borrowers are generally 55% to 60% (allowing a buffer for the real estate market to crash by 40% to 45% before threatening a capital loss).
          2. Government support: borrowers are being provided with paycheck support until economies re-open and they are able to return to work
          3. Spread: 哈灵麻将去哪里找群啊 grade (NAIC 2) instruments that yield between +400bp and +600bp, depending on modeling assumption

          As we evolve our Act 1 Strategy, we will keep a close eye on the opportunity set as the time will come when a full rotation to our Act 2 Strategy will be warranted.

          Full roadmap to Act 2: trigger points for walking and running

          We believe there will be an attractive entry point for investors in structured credit in more complex or more junior instruments when we have greater clarity on the economic recovery and when it becomes possible to once again model the future.

          These transactions have seen their spreads increase significantly since pre-COVID-19 and offer potential opportunity when the time is right. See Figure 3 for just some examples from a very large universe.

          Figure 3: Examples of potential developing Act 2 opportunities5

          Sector

          Target spreads (pre-COVID)

          Target spreads (now)
          RMBS UK BBB 175 400
          CRT US B1/B2 250 600
          RMBS AU BBB 300 600
          Aircraft ABS A 225 800
          Unsecured Consumer US BBB 200 1000
          CLO BBB 330 600
          Subprime Auto BBB 150 500


          But in order to invest in these, we need greater certainty and so are waiting for the following triggers:

          • Q2 and Q3 remittance data across securitized sectors which will show the rate of borrowers moving from forbearance to either default or performing
          • Better economic data which will provide clues to what type of recovery we should expect, allowing us to model forecasted losses with our customary level of precision.

          We are actively looking for these triggers on a daily basis and encouraged that an attractive opportunity set is evolving around us.

          The time will come for extracting the credit component in structured credit. We are watching closely for that inflection point as we get ready to walk and run.

           

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