FOR PROFESSIONAL CLIENTS ONLY.
NOT TO BE DISTRIBUTED TO RETAIL CLIENTS.
CAN EXTRA YIELD BE SECURED
WITHOUT SACRIFICING
CREDIT QUALITY?
A TOTAL MARKET APPROACH TO SECURED FINANCE
MARCH 2017
>S
ecured finance provides a huge variety
of potential yield pick-up opportunities
across risk and market types. Selecting
from investments across the entire
range of public and private debt markets
enables investors to target diverse
streams of stable, long-term,
high-quality cash flows.
Alex Veroude, CFA, Head of Credit and Deputy Head of
Fixed Income (New York)
Alex joined the Fixed Income Group at Insight in July 2007 as
Head of Credit, overseeing all credit activities with responsibility
also for setting credit strategy. He also became Deputy Head
of Fixed Income (New York) in June 2016. Alex oversees a team
of more than 40 credit analysts covering corporate issuers
(investment grade and high yield) as well as secured finance.
Alex is lead portfolio manager of the Absolute Insight Credit
Fund, the Secured Finance Fund, the Consumer Debt Recovery
Fund and a number of customised separate accounts. He holds
a first class equivalent MSc in Quantitative Economics from
Tilburg University in the Netherlands, is fluent in English,
Dutch, German and Swedish and is a CFA charterholder.
SECURING EXTRA YIELD
WITHOUT SACRIFICING QUALITY
LOW YIELDS PRESENT DUAL CONCERNS FOR INSTITUTIONAL CLIENTS. THEY MAKE IT DIFFICULT TO SOURCE
HIGH-QUALITY ASSETS THAT PAY REGULAR CASH FLOWS AND PUT THE CAPITAL VALUE OF FIXED-RATE
PORTFOLIOS AT RISK OF A POTENTIAL RISE IN INTEREST RATES OVER THE LONGER TERM.
QUALITY, COLLATERAL AND YIELD PICK-UP
Secured finance is a $30trn global market place incorporating a
range of public and private investments which share the common
feature that they are secured by collateral and a recurring income
stream. They can serve to generate an attractive yield compared
to equivalent investment grade securities such as bonds.
Insight’s strategy is to select from among the best investments
across the complete spectrum of public and private investment
opportunities to construct portfolios of varying degrees of
liquidity. A client invested in our secured finance investment
strategy receives a diversified set of consumer, corporate and
asset-based cash flows. Our team manages £8.9bn/€10.2bn
in assets under management and possesses complementary
experience in sourcing, underwriting, structuring, closing and
trading, integrated into a market-leading fixed income, credit
and risk management platform.
We aim to provide investors with the means to invest in credit
opportunities beyond the traditional investment grade corporate
bond space, without compromising credit quality and targeting
returns in line with investment grade corporate bonds. Where
possible, we search for investment opportunities where we have
specialist expertise and enter those selectively, before they
become crowded. This approach seeks to deliver attractive
risk-adjusted returns, while enabling us to negotiate better
investment terms.
Insight offers access to secured finance opportunities through
multi-client pooled vehicles or individually designed portfolios.
By tailoring the strategy, credit quality, maturity and payout
profiles, we can construct solutions to meet a client’s specific
long-term objectives. For example, our bespoke solutions help
pension schemes meet liabilities with high-quality cash flows.
Insight’s proven track record across securitisation and collateralbased lending is underpinned by a robust investment process
incorporating top-down credit strategy and bottom-up
underwriting. Portfolios are created using a proprietary asset
allocation model for liquid and illiquid credit, with a focus on
high-quality, low-risk opportunities. Credit underwriting
experience is paramount and Insight has a strong history of
default avoidance, backed by private credit rating models and
disciplined risk control management overseen by an experienced
investment committee.
THE INSIGHT PROCESS: MAPPING THE CREDIT
UNIVERSE
Insight characterises the credit markets according to the amount
of credit risk they represent and their liquidity. This taxonomy is
illustrated by the quadrant diagram below (Figure 1).
The horizontal axis shows the available liquidity for investment
instruments. For example investment grade bonds are more liquid
than loans and private debt. The vertical axis depicts the amount
Figure 1: Mapping the credit universe
Mid-market private debt
Mezzanine, second lien
Distressed debt
High yield bonds
Bank loans
Residential and consumer
Commercial real estate (CRE)
Secured corporates
Investment grade bonds
Credit risk
Higher
Lower
Secured
finance
For illustrative purposes only.
Lower
Higher
Liquidity
of credit risk for each investment type. For example, subinvestment grade securities have higher credit risk than
investment grade securities.
There are essentially three categories:
1. Consumer cash flows: This includes paying mortgages and
credit card and utility bills. As long as the consumer is in good
financial health, cash flows are secure. This risk can be
purchased in either the public bond markets or via the
private market.
Secured finance
investments present a
highly attractive option
for fixed income investors
seeking a combination
of higher yield relative to
investment grade corporate
bonds without having to
compromise on credit quality.
2. Asset-based cash flows: Cash flows come from the availability
and utilisation of the asset. This may include buildings that are
rented out, and infrastructure such as hospitals, railways and
motorways.
3. Corporate cash flows: Companies produce goods and
services and sell on that cash flow. This cash flow can be
purchased in either the public bond markets (via securitisations)
or the private market.
Apportioned across the private and public debt space, these three
categories produce six investment outcome possibilities as
depicted in Figure 2.
Consequently, secured finance provides substantial diversity
across risk and market types, enabling investors to model
outcomes depending on what yield pick-up is available among
the different sectors.
WHICH INVESTMENT TYPES DO WE FOCUS ON?
Understanding the risks within secured finance requires tracing
the unit of dollar, euro or pound cash flow that an investment is
producing in order to identify who is paying the income stream
to the buyer of this fixed income instrument.
The ability to manage portfolios by selecting from investment
opportunities across the entire market to target diverse streams
of stable, long-term, high quality cash flows is the value
proposition of secured finance at Insight.
Figure 2: Which investment types do we focus on?
Consumer cash flows
Public
Asset-based cash flows
Prime residential mortgage-backed
securities (RMBS)
Commercial mortgage-backed securities
(CMBS)
Buy-to-let RMBS
Infrastructure bonds
Corporate cash flows
Collateralised loan obligations
Whole business securitisations (WBS)
Non-conforming RMBS
Private
Mortgage warehouse
CRE loans
Corporate loan warehouse
Bridge lending
Infrastructure loans
SME warehouse
Auto/credit card warehouse
For illustrative purposes only.
WHAT IS THE ATTRACTION OF
SECURED FINANCE?
Insight’s secured finance strategy aims to offer favourable
risk-adjusted returns against comparable investment grade
corporate bonds based on equivalent ratings (Figure 3) by
optimising from a combination of investments across the six
areas within secured finance. For the same amount of default
risk, investors can use secured finance investments to potentially
attain an additional c.250bp in yield without adjusting their credit
risk profile.
In addition to this, high quality secured finance investments
provide significantly higher levels of senior collateral, given that
they are typically backed by a portfolio of physical assets
providing investors with tangible security, compared to unsecured
investment grade bonds. Moreover, secured finance assets
typically provide a floating rate which, unlike fixed rate bonds, may
help mitigate the price impact of rising interest rates.
Investors may attribute the higher yield available on secured
finance investments to three broad factors: a changing
lending market; the complexity of the underlying assets;
and their illiquidity.
forced to reduce the scale of their lending as a result of increased
regulatory capital requirements, leading to wider secured credit
spreads and creating permanent opportunities for other longterm investors to provide lending.
The illiquidity premium represents the additional return an
investment generates for tying up capital. Investors derive a
return based on the fundamental characteristics of an investment
and avoid the pitfalls of sentiment-driven selling when market
conditions turn.
The complexity premium represents the additional return that an
investment presents to access and assess investments. A high
level of expertise is necessary across a range of specialisms from
legal to accounting to portfolio management as well as access to a
broad network.
In essence, the credit quality of secured finance can approximate
to investment grade bonds. Investors are able to gain exposure
to a portfolio of asset-backed securities and loans tied to specific
economic activities that generate income streams while receiving
an enhanced yield. A portfolio of well-chosen secured finance
investments further enhances the risk and return profile of
this opportunity.
This unique opportunity has arisen as a consequence of changes
in the lending markets since the financial crisis. Banks have been
Spread over 3month Libor (bp)
Figure 3: Attractive risk-adjusted returns – investment grade corporate spreads versus secured debt
550
500
450
400
350
300
250
200
150
100
50
0
Insight secured
finance strategy
+252bp
AAA
AA
A
BBB
Investment grade
Representative secured finance universe
Investment grade corporate bonds
Source: Insight as at 31 December 2016. The spreads shown are for illustrative purposes only and are not indicative of the strategy spread.
BB
High yield
IMPLEMENTING SECURED FINANCE:
A RECENT EXAMPLE
Below, we show how we restructured a representative single
corporate bond portfolio with an average credit rating of A/BBB,
yielding 158bp over swaps in July 2015, to achieve a higher yield
using secured finance investments. Following the restructuring
exercise the portfolio was able to generate 325bp over swaps by
December 2016. The evolution of this portfolio adjustment and
the progression in yield enhancement is shown in Figure 4.
Throughout the restructuring process we maintained the average
credit quality of the portfolio at A/BBB. From July 2015 to
December 2016, credit spreads on A/BBB investment grade
corporate bonds were broadly unchanged, but they experienced
material volatility over the period, particularly during early 2016.
Figure 4: Implementing secured finance – a recent example
350
300
250
bp
200
150
100
50
0
Jul 15
■
Corporate bonds
Sep 15
■
Secured finance
Dec 15
Mar 16
■ Cash conversion
Jun 16
Sep 16
Dec 16
Actual spread
Source: Bloomberg, data as at 30 December 2016. Shows the evolution through time of the spread generated by a portfolio which went from fully invested in IG Corp.
to 70% IG SECFIN/30% IG Corp.
Past performance is not a guide to future returns. The yield shown is net of fees. The results shown are intended to demonstrate our ability to manage this asset
class and are not a guarantee of future returns. Actual client returns may differ materially and will depend on the individual circumstances of each client.
SUMMARY
The breadth and depth of secured finance markets can confer investors with the benefit of substantial diversification across different types
of risk. Investments that derive cash flows from unrelated economic participants across geographies and industries translate into low
correlations between underlying component investments. Consequently a portfolio of well-chosen investments, selected from across the
entire secured finance market, can offer investors an attractive return for the risk taken in our view.
In essence, an investor receives recurring high-quality, floating interest rate cash flows backed by senior secured collateral across multiple
sources. Capturing illiquidity and complexity premia potentially enables investors to generate an additional yield from a wide range of real
economy investments.
GLOSSARY
Asset-backed security (ABS): Bonds or notes backed by a pool of assets,
such as car loans or credit card receivables.
Liabilities: The projected cash flows that a pension scheme, or insurance
company, is committed to pay out to its members.
Bond: A tradeable loan issued by a borrower for a fixed period of time
paying interest, known as the coupon, which is fixed at the issue date and
is paid regularly to the holder of the bond until it is redeemed at maturity
when the principal amount is repaid.
Liquidity: The ease with which buying and selling takes place in the market.
Liquidity can be measured by the daily trading volume in a security.
Bridge lending: A bridge loan is a short-term loan used until a person or
company secures permanent financing or removes an existing obligation.
This type of financing allows the user to meet current obligations by
providing immediate cash flow.
Collateral: An asset that is accepted by a lender as security.
Collateralised loan obligation (CLO): A form of securitisation where
payments from multiple middle sized and large business loans are pooled
together and passed on to different classes of owners in various tranches.
Commercial real estate loan (CRE): A loan secured on commercial property
such as offices, hotels, retail parks, industrial parks, leisure and mixed use.
Corporate bond: A debt obligation issued by a private or public company.
Credit default risk: The risk that a loss will be experienced due to a default
by the issuer of a bond, or counterparty in a swap transaction.
Credit spread: The difference in yield between a reference security and
some benchmark yield (usually the government or swap yield) where the
securities are identical in all respects except for credit quality. Credit spreads
will generally be higher for companies with lower credit ratings to
compensate investors for the additional risk undertaken.
Default: Failure to meet an obligation such as timely payment of interest
or principal.
Distressed debt: Debt of companies with an impending or actual
covenant default.
Diversification: A way of reducing risk by spreading investments among a
number of different assets and strategies that are not perfectly correlated
so that losses in any one asset class may be offset by gains in another.
High yield bond: A bond rated at or below a certain rating, typically BB,
because of its high default risk. High yield bonds pay higher yields in order
to compensate bondholders for the additional credit risk over and above
less risky (investment grade-rated) bonds.
Infrastructure bond: Borrowing to be invested in government-funded
infrastructure projects within a country. They are issued by governments
or government-authorised Infrastructure companies or non-banking
financial companies.
Investment grade bonds: A bond that has a credit rating, typically of BBBor higher. Generally they are judged by rating agencies as likely enough to
meet payment obligations that banks are allowed to invest in them.
Maturity: Length of time until the last interest payment and the principal of
a bond is redeemed.
Mezzanine financing: A hybrid of debt and equity financing that gives the
lender the rights to convert to an ownership or equity interest in the
company in case of default, after venture capital companies and other senior
lenders are paid.
Middle market debt: Generally smaller companies than those we see in the
high-yield bond market and the syndicated term loan market.
Mortgage-backed securities (MBS): An investment instrument that
represents ownership of an interest in a pool of mortgages. Principal and
interest from the individual mortgages are used to pay principal and interest
on the MBS.
Pooled fund: Vehicle in which a number of investors pool their assets so
that they can be managed on a collective basis. This usually suits investors
wishing to invest in a broad spread of investments. Holdings in a pooled
fund are denominated in units or shares that are re-priced regularly to reflect
changes in the value of underlying assets. This allows investors to value their
holdings and provides a basis upon which transactions into and out of the
fund can take place.
Residential mortgage-backed securities (RMBS): Secured on a pool of
residential mortgages. These are typically amortising, meaning that the
cash flows will include both interest and principal payments. The underlying
mortgages can have varying characteristics, and may include prime,
buy-to-let and non-conforming mortgages.
Syndicated loan: A loan offered by a group of lenders – referred to as a
syndicate – that work together to provide funds for a single borrower.
Unsecured debt: A debt obligation with no collateral and backed only by
the debtor’s creditworthiness.
Warehouse lending: A warehouse line of credit is provided to mortgage
lenders by financial institutions. The lenders are dependent on the eventual
sale of mortgage loans to repay the financial institution and to make a profit.
Whole business securitisation: A way that companies can raise capital that
they need to remain operational. Securitisation refers to the process where
a corporate entity takes certain assets and converts them into securities that
it can offer for sale.
Yield: The percentage return paid on a stock in the form of a dividend or the
effective rate of interest paid on a bond.
FIND OUT MORE
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[email protected]
+44 20 7321 1552
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[email protected]
+44 20 7321 1023
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[email protected]
+44 20 7321 1928
Client Relationship Management
[email protected]
+44 20 7321 1499
@InsightInvestIM
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