- Structured credit can help augment yield and total return in a low interest rate environment
- Investors can benefit from its complementary risk/return profile relative to traditional fixed income
- Structured credit can help investors address the risk of rising interest rates
- Regulatory changes have mitigated many of the risks that led to the Great Financial Crisis
- Easterly Income Opportunities Fund (JSVIX): The Fund seeks to provide a high-level of risk-adjusted current income and capital appreciation. Capital preservation is a secondary objective.
This primer provides an overview of these areas:
- What is Structured Credit?
- Key Features and Benefits
- Evolution of Structured Credit
- Case for Structured Credit in a Rising Rate Environment
What is Structured Credit?
Structured Credit includes non-traditional bonds securitized by specific pools of collateral, such as residential and commercial mortgages, consumer loans or commercial loans. Figure 1 summarizes the major sectors. Through a process called securitization, loans with similar characteristics are purchased and pooled in a trust-like entity known as a Special Purpose Vehicle (SPV). The SPV then issues securities backed by the principal and interest cash flows of the collateral pool that exhibit a variety of characteristics in terms of coupon, maturity, price, yield and credit quality.
|Non-Agency RMBS||Non-Agency Residential Mortgage-Backed Securities: Backed by diversified pools of residential mortgages created by private entities|
|CMBS||Commercial Mortgage-Backed Securities: Backed by a diversified pool of commercial mortgages|
|Consumer ABS||Consumer Asset-Backed Securities: Backed by loans & receivables from consumers (e.g. Auto Loans, Credit Card Receivables, Student Loans)|
|Commercial ABS||Commercial Asset-Backed Securities: Backed by commercial loans, leases and receivables as well as corporate leveraged loans (e.g. Collateralized Loan Obligations or CLOs)|
Key Features and Potential Benefits of Structured Credit
Structured Credit can benefit investors in a number of ways, including the potential for relatively high risk-adjusted returns, attractive monthly income, portfolio diversification, and limited exposure to duration and credit risk.
Non-Indexed and Inefficient: Because non- agency structured credit exists outside of major indexes, it may provide investors access to fixed income market segments that have not been commoditized by major benchmarks and ETFs. In addition, the inefficient and complex nature of the space allows for highly experienced managers to exploit price dislocations.
Floating Rate: Many structured credit products offer a “floating” or variable rate. Similar to more commonly known bank loans, the coupon offered is typically a spread above a benchmark rate, such as LIBOR. This can be particularly appealing when interest rates are rising.
Risk-Adjusted Yield Premium: Structured Credit typically offers investors attractive yield per unit of duration relative to traditional fixed income. (See Figure 2)
Tranched Risk: While the collateral is made up of pools of loans with similar characteristics, Structured Credit securities are typically tranched into a capital structure through a process known as subordination (See Figure 3). Each tranche is offered separately, and each has a distinct risk/return profile. The more senior tranches typically have less exposure to credit risk and, as a result, have lower yields. Conversely, the more junior the tranche, generally the higher the levels of credit risk and yield. (See Figure 3) This allows investors a broad spectrum of options to satisfy their risk/reward preferences.
Credit Enhancement: In addition to subordination described above, structured credit may offer another advantage over traditional fixed income: credit enhancement, through overcollateralization and excess spread. This can help mitigate credit risk and can provide a buffer against loss.
Diversification: Structured credit potentially offers diversification at both the loan and the portfolio level. At the loan level, structured credit securities are typically collateralized by a diverse pool of similar assets such as loans. This diversifies the collateral pool, reducing idiosyncratic credit risk of all tranches in the deal. At the portfolio level, investors can gain exposure to a part of the fixed income market that exists outside major indexes and ETFs. In addition, structured credit has historically had low correlation among its sub- sectors as well as to traditional fixed income sectors.
Structured Credit Sectors Provide More Yield Per Unit of Duration
Source: Bloomberg, J.P. Morgan, Orange Investment Advisors. As of 3/17/2023.
Blue represent structured credit sectors and gray bars represent traditional fixed income categories.
CLO is represented by BBB CLO Index
RMBS Index is represented by CRT M1 OTR (rated A/BBB)
ABS is represented by Auto ABS Subordinate Composite Index
CMBS Index is represented by Conduit “A” rated 2014 vintage
Treasuries, Corporates, Agencies, Agency MBS and High Yield represented by the Bloomberg Indices.
Figure 3: Capital Structure Resulting From Subordination
|CAPITAL STRUCTURE RESULTING FROM SUBORDINATION|
|Senior Tranches||▪ Highest ratings; investment grade
▪ Last in capital structure to incur losses
▪ Receive principal payments first
▪ Lowest yield in capital structure
|Mezzanine Tranches||▪ Subordinate to senior tranches
▪ Typically investment grade; can be slightly below
▪ Absorb losses only after junior tranches are written off
▪ Receive principal sequentially after seniors
▪ Yields between senior and junior tranches
|Junior Tranches||▪ Subordinate to mezzanine tranches
▪ Unrated or below investment grade
▪ First in capital structure to incur losses
▪ Last in capital structure to receive principal
▪ Highest yield in capital structure
Evolution of Structured Credit
Since the global financial crisis, the structured credit market has undergone significant changes and enhancements. Numerous regulatory changes, including the Dodd-Frank Act and the Volker Rule within the United States and Basil III globally, have resulted in tighter lending standards, increased disclosure and reporting, greater risk retention by originators and increased capital requirements. These changes have led to increased oversight and protections for investors as well as reduced abuses by originators. Below are several key examples of types of credit enhancements and safeguards offered within structured credit.
Key Risks to Investing in Structured Credit
Every investment comes with risks. In fixed income, typical risks include interest rate risk, credit risk, liquidity risk and prepayment risk. Risks specific to structured credit include:
Interest rate risk: Rapid and dramatic shifts in interest rates may affect the value of a structured credit bond. Rate movements may also indirectly affect pre-payment or extension risk, which are essentially the risks of a callable bond being called sooner or later than projected by the investor.
Credit risk: Unlike an Agency bond that is backed by the U.S. Government, credit risk cannot be totally eliminated within non-agency structured credit, particularly in lower-rated, subordinate bonds.
Liquidity risk: Structured credit products may trade less frequently than other fixed-income products, making them somewhat less liquid. This is directly related to the fact that they are non-index, which is also the source of market inefficiency. This risk can normally be effectively managed by experienced Structured Credit traders, but nonetheless will increase at times of heightened market volatility.
Complexity risk: While pooling multiple loans helps to diversify idiosyncratic credit risk, the Structured Credit market is complex and diverse, made up of a variety of deal structures and collateral types that require specialized expertise and resources.
The Case for Structured Credit in a Rising Interest Rate Environment
After suffering through one of the worst years in history amidst considerable fund outflows bonds are bound to perform well given attractive yield profiles across most fixed income sectors. Given that we are likely to enter a recession by Q1 2024 and equity valuations are not currently attractive, fixed income should be a must in all investors’ portfolios.
The regime of steady, low interest rates is over, and interest rate volatility is likely to persist for the foreseeable future. The current volatile interest rate environment is yet another example of how difficult it is to predict and market-time interest rates. Therefore, a fixed income strategy that generates attractive returns without taking unnecessary interest rate risk may lead to higher quality returns.
Within fixed income, it is important to focus on strategies that maximize yield while minimizing duration to remove interest rate risk while retaining income. As highlighted in the chart above, structured credit is positioned to achieve these aims, with yields per unit of interest rate risk being the highest in almost 20 years. In particular, expected flows into fixed income will likely find their way to structured credit bonds, which are now offering 7-9% returns for investment grade cashflows with relatively low duration, something not seen in a generation. We believe that, as demand materializes, particularly in the absence of new issue supply that is expected to be curtailed due to higher rates, spreads will most likely tighten resulting in capital appreciation on top of higher yields.
Going into a recession, fundamental credit risk may be harder to quantify in Corporate credit sectors such as IG Corporates, High Yield and Levered Loans than in Structured credit sectors such as RMBS, CMBS, ABS and CLOs. This is because Structured credit bonds, which are securitizations of loans and other assets, benefit from structural advantages in the form of excess spread, senior/subordinate tranches, interest diversion mechanisms, over-collateralization and interest coverage tests, etc. which may provide investors with less credit risk.
Finally, within fixed income, structured credit sectors offer higher risk-adjusted returns and opportunities for alpha because they are not indexed and is therefore priced more inefficiently than indexed traditional fixed income sectors. A bottom-up, active, value-based security selection strategy is the ideal approach to capture these market inefficiencies and excess returns available in Structured credit.
Figure 4: Comparison of Bond Category Performance
|Comparison of Bond Category Performance|
|Morningstar Category||YTM||Avg. Price||Avg. Duration||1-Year Returns||SI Returns*|
|Bank Loan||10.67 %||-||0.40||-2.93%||4.81%|
|High Yield Bond||7.63%||$92.54||3.65||0.85%||2.21%|
|Intermediate Core Bond||4.73%||$92.76||6.00||-5.15%||0.58%|
|Intermediate Core Plus Bond||5.14%||$94.54||6.17||-5.19%||0.99%|
All data as of 3/31/2023 unless otherwise noted.
*Annualized returns since 8/21/2018, the inception of JSVIX
In the table above, we illustrate the low and even negative total returns that result from low yield and/or high duration in a rising rate environment such as the first quarter of 2021 or calendar year 2022. Even short to intermediate-term bond fund categories had negative total returns, while strategies with greater credit exposure were still only marginally positive.
There is no guarantee that an investor would experience these results going forward, but it points to the potentially attractive features of structured credit, particularly in today’s environment of still relatively low but rising interest rates.
Conclusions: A Niche Where Expertise Matters
Overall, we see structured credit as an important piece of a properly diversified portfolio. By including exposure to structured credit within their diversified bond portfolios, investors can potentially increase their overall risk-adjusted yield while including an asset class with low correlations to other market sectors. And in a period of rising rates, structured credit’s risk/return profile can be even more attractive.
Because structured credit is a specialized part of the fixed income market, investors may benefit most from working with an experienced manager who can understand, identify and unlock the value that this may offer market offers.
To learn more about structured credit and how you could potentially enjoy its numerous potential benefits, contact us at email@example.com or call (888) 814-8180.
Performance as of 3/31/2023
|3/31/2022||QTD||1-Year||3-Year||Since Inception (8/21/2018)|
|Morningstar Multisector Bond Category||2.39%||-3.67%||2.77%||1.45%|
|Bloomberg U.S. Aggregate Bond Index||2.96%||-4.78%||-2.77%||0.86%|
Past performance is not a guarantee nor a reliable indicator of future results. As with any investment, there are risks. There is no assurance that any portfolio will achieve its investment objective. Mutual funds involve risk, including possible loss of principal. The Easterly Funds are distributed by Ultimus Fund Distributors, LLC. Easterly Funds, LLC and Orange Investment Advisors, LLC are not affiliated with Ultimus Fund Distributors, LLC, member FINRA/SIPC. Certain associates of Easterly Funds, LLC are registered with FDX Capital LLC, member FINRA/SIPC.
Average Duration: Average duration is generated by Morningstar from the categories funds by weighting the effective duration of each fund’ portfolio by its relative size in the category.
Average Price: Average price is generated by Morningstar from the categories funds by weighting the average price of each fund’s portfolio by its relative size in the category.
Bloomberg Barclays U.S. Aggregate Index: A broad bond index covering most U.S. traded bonds and some foreign bonds traded in the U.S. The Index consists of approximately 17,000 bonds.
Effective Duration: This measure of duration takes into account the fact that expected cash flows will fluctuate as interest rates change and is, therefore, a measure of risk. Effective duration can be estimated using modified duration if a bond with embedded options behaves like an option-free bond.
Morningstar Bank Loan Category: Bank loan portfolios primarily invest in floating-rate bank loans instead of bonds.
Morningstar High-Yield Bond Category: High-yield bond portfolios concentrate on lower-quality bonds, which are riskier than those of higher-quality companies.
Morningstar Intermediate Core Bond Category: Intermediate-term core bond portfolios invest primarily in investment-grade U.S. fixed-income issues including government, corporate, and securitized debt, and hold less than 5% in below-investment-grade exposures. Their durations (a measure of interest-rate sensitivity) typically range between 75% and 125% of the three-year average of the effective duration of the Morningstar Core Bond Index.
Morningstar Intermediate Core-Plus Bond Category: Intermediate-term core-plus bond portfolios invest primarily in investment-grade U.S. fixed-income issues including government, corporate, and securitized debt, but generally have greater flexibility than core offerings to hold non-core sectors such as corporate high yield, bank loan, emerging-markets debt, and non-U.S. currency exposures. Their durations (a measure of interest-rate sensitivity) typically range between 75% and 125% of the three-year average of the effective duration of the Morningstar Core Bond Index.
Morningstar Multisector Bond Category: Multisector-bond portfolios seek income by diversifying their assets among several fixed income sectors, usually U.S. government obligations, U.S. corporate bonds, foreign bonds, and high-yield U.S. debt securities.
Morningstar Nontraditional Bond Category: The Nontraditional Bond category contains funds that pursue strategies divergent in one or more ways from conventional practice in the broader bond-fund universe.
Morningstar Short-Term Bond Category: Short-term bond portfolios invest primarily in corporate and other investment-grade U.S. fixed-income issues and typically have durations of 1.0 to 3.5 years.
Spread Duration: The sensitivity of the price of a security to changes in its credit spread. The credit spread is the difference between the yield of a security and the yield of a benchmark rate, such as a cash interest rate or government bond yield.
Yield per unit of duration: Is the funds yield to maturity divided by the fund’s duration.
YTM: Yield to Maturity (YTM) is the total return anticipated on a bond if the bond is held until it matures. Yield to maturity is considered a long-term bond yield but is expressed as an annual rate.
Investors should carefully consider the investment objectives, risks, charges and expenses of the Fund. This and other information is contained in the Fund’s prospectus, which can be obtained by calling 888-814-8180 and should be read carefully before investing. Additional Fund literature may be obtained by visiting www.EasterlyFunds.com.
Important Fund Risks
There is no assurance that the portfolio will achieve its investment objective. A CLO is a trust typically collateralized by a pool of loans. A CBO is a trust which is often backed by a diversified pool of high risk, below investment grade fixed income securities. A CDO is a trust backed by other types of assets representing obligations of various parties. For CLOs, CBOs and other CDOs, the cash flows from the trust are split into two or more portions, called tranches. MBS and ABS have different risk characteristics than traditional debt securities. Although certain principals of the Sub-Adviser have managed U.S. registered mutual funds, the Sub-Adviser has not previously managed a U.S. registered mutual fund and has only recently registered as an investment adviser with the SEC.
Easterly Funds, LLC and Easterly Investment Partners, LLC both serve as the Advisors to the Easterly Fund family of mutual funds and related portfolios. Both Easterly Funds, LLC and Easterly Investment Partners, LLC are registered as investment advisers with the SEC. Mutual Funds are distributed by Ultimus Fund Distributors, LLC, member FINRA/SIPC. Although Easterly Funds, LLC and Easterly Investment Partners, LLC are registered investment advisers, registration itself does not imply and should not be interpreted to imply any particular level of skill or training.
THE OPINIONS STATED HEREIN ARE THAT OF THE AUTHOR AND ARE NOT REPRESENTATIVE OF THE COMPANY. NOTHING WRITTEN IN THIS COMMENTARY OR WHITE PAPER SHOULD BE CONSTRUED AS FACT, PREDICTION OF FUTURE PERFORMANCE OR RESULTS, OR A SOLICITATION TO INVEST IN ANY SECURITY.
Diversification does not ensure a profit or guarantee against loss.