Securitised Credit - Income Generation in 2023

Introduction

Soaring interest rates, persistently high inflation and stalling economic growth are combining to create a challenging environment for investors, particularly those focused on traditional fixed income strategies. We believe Institutional investors should consider the less common areas of the asset class during these times, and that Securitised Credit strategies are among the most attractive.

In this article we review the key features of Securitised Credit, highlighting the potential diversification benefits from investing in this fixed income sub asset class. This includes the floating rate nature of the investments, the potential for credit enhancement to reduce risk, and the expectation for returns to be stable and lowly correlated with those of traditional assets.

In recognition of these positive characteristics, investors have been allocating to Securitised Credit strategies in recent years.

The value of investments and any income from them can go down as well as up and investors may not get back the amount originally invested.

The Floating Rate Benefit of Securitised Credit

In response to high levels of inflation, central banks around the world have taken hawkish stances, signalling their willingness to continue raising rates, even at the expense of slower economic growth. As interest rates have risen, traditional fixed income investments have incurred losses. For Securitised Credit however, where most exposure is floating rate, coupons increase in line with interest rates, meaning there is very limited interest rate risk. As a consequence, limited capital losses are associated with these rate rises.

As a consequence, the floating rate feature of Securitised Credit means that the asset class may be expected to perform better than traditional fixed income asset classes in rate rising environments, all else equal. However, it also means that the correlation of these investments with other parts of an investor’s portfolio will likely be low, implying exposure will provide important diversification benefits.

At HSBC, we invest only in the distributed Securitised market, displayed by the red portion of the left-hand pie chart in the chart below. In doing so, we exclude the fixed rate Mortgage-Backed Security part of the market from our Securitised Credit investment universe. As shown by the right-hand pie chart, our investable universe provides ample opportunity for diversification across various market segments, with this part of the market representing around USD 4tr of mainly floating rate securities.

Sources: HSBC Asset Management; Australian Statistics Bureau; Reserve Bank of Australia, JPMorgan, BAML, Barclays; Data as at May 2023.

Controlling Risk within Securitised Credit

Whilst Securitised Credit investments may demonstrate resilience during periods of market stress, as with any investment there are risks that need to be evaluated when investing in the asset class. The key risks include:

1. Credit Spread Risk:
   The risk that should credit spreads widen, Securitised Credit investments may incur mark to market losses
2. Default Risk:
   Like all credit investments, there is a risk that creditors default, which for Securitised Credit would occur for the loans within a securitisation

At HSBC, we see limited Credit Spread Risk in the current environment, with spreads already relatively wide, reflecting the current risk-off market tone and poor global economic outlook. On the contrary, with prices comparatively depressed, this may actually present an attractive opportunity. Whilst default risk clearly remains, as the below diagram shows, for Securitised Credit, Securitisations occur through Special Purpose Vehicles (SPVs), that are separate legal entities used to ring fence and orient the risk of the Securitisation towards the underlying pool of collateral. This structure brings with it the potential for Credit Enhancement, with multiple tranches of debt available at various levels of seniority, and investors only incurring losses should total losses exceed the amount of credit enhancement behind the selected tranche.

Sources: HSBC Asset Management.

A variety of methods may be used to determine the risk within a Securitised Credit investment, and at HSBC we believe Stress testing to be an important consideration. An example of the stress tests we conduct is shown in the table below¹, which demonstrates the economic stresses that a Collateralised Loan Obligation (CLO) can withstand.

As part of the HSBC Securitised Credit investment process, every candidate security undergoes stress testing, which conveys the likely impact on a security of various shocks or scenarios. We use a Global Financial Crisis (GFC) stress, where we apply an annual default peak rate of 8.25 per cent and a loan recovery of 60 per cent (slightly lower than the 80 per cent actually experienced). We also scale this scenario up, in order to assess the impact from more volatile periods.

Source: HSBC Asset Management as at 31 May 2023 and subject to change.

• Scenario 1:
  Short, sharp ‘Covid-19 shock’ with loan defaults peaking at similar levels to peak 2008/9 Global Financial Crisis and 60 per cent loan recovery rate
• Scenario 2:
  Loan defaults peaking at 2x peak 2008/9 Global Financial Crisis levels and 50 per cent loan recovery rate
• Scenario 3:
  Loan defaults peaking at 3x peak 2008/9 Global Financial Crisis levels and 40 per cent loan recovery rate

Individual managers and transactions vary making security selection critical.

Further to this, data from Fitch, shown in the table below², demonstrates how resilient the Securitised Credit sector was over the GFC, with only 2 sub-sectors experiencing significant distress: US Non-Conforming RMBS (often Subprime Mortgages) and Collateralised Debt Obligations (CDOs), where junior tranches of Subprime RMBS were used as collateral. This analysis demonstrates that it may be possible to control risk by focusing on specific areas of Securitised Credit, whilst avoiding others. For example, some asset managers’ funds only invest across AAA, AA & A-rated bonds which, as shown in the first table above, avoided credit losses in the 3 times GFC stress test.

Global Securitised Finance Losses: 2000 – 2018 Issuance

Sources: Fitch Ratings, Global Securitised Finance Losses: 2000 – 2018 Issuance, Special Report US Jul 2019; Special Report EMEA May 2019.

Sources: Fitch Ratings, Global Securitised Finance Losses: 2000 – 2018 Issuance, Special Report US Jul 2019; Special Report EMEA May 2019.

Simulated data is shown for illustrative purposes only and should not be relied on as indication for future returns. The level of yield is not guaranteed and may rise or fall in the future.
Source: HSBC Asset Management as at 31 May 2023 and subject to change. (1) The scenarios presented are an estimate of future performance based on evidence from the past on how the value of this investment varies, and/or current market conditions and are not an exact indicator. What you will get will vary depending on how the market performs and how long you keep the investment/product. Future performance is subject to tax which depends on an investor’s personal circumstances and it may change in the future. Investors may suffer financial loss if there is no guarantee in place. (2) Sources: Fitch Ratings, Global Securitised Finance Losses: 2000 – 2018 Issuance, Special Report US Jul 2019; Special Report EMEA May 2019. Simulations are based on Back Testing assuming that the optimisation models and rules in place today are applied to historical data. As with any mathematical model that calculates results from inputs, results may vary significantly according to the values inputted. Prospective investors should understand the assumptions and evaluate whether they are appropriate for their purposes. Some relevant events or conditions may not have been considered in the assumptions. Actual events or conditions may differ materially from assumptions. Past performance is not a reliable indication of future returns.

The Securitised Credit Return Profile

The low interest rate sensitivity of Securitised Credit and its low correlation with traditional asset classes makes it an appealing asset class for institutional investors to consider from a diversification standpoint. However, Securitised Credit is also a credit market that offers relatively attractive levels of income, given the integration of both complexity and illiquidity premiums. This makes the asset class appealing from a cash flow perspective, making it a potentially useful component of clients Cash Flow Driven Investment solutions.

HSBC’s Global Approach to Securitised Credit Investing

At HSBC our approach to Securitised Credit investing can be summarised by our use of extensive resources, active management, a global approach and the integration of ESG.

Extensive Resources

Whilst assessing the risks mentioned in the previous section is critical, it is worth noting that Securitised Credit risks have been mitigated somewhat since the GFC, with the quality of loans inside securitisations improving. This has been mainly driven by two factors:

• Countries increasing regulation of residential mortgage markets
• Securitisation processes themselves experiencing regulation and reform

That said, to properly evaluate risks and opportunities within Securitised Credit markets it is imperative to have a robust and well-established Credit Analysis process. As shown by the graphic below, HSBC has one of the largest and most experienced investment teams in the market.

Source: HSBC Asset Management as at 31 May 2023 and subject to change.
(1) Indicates members of the Investment Forum Team members and those highlighted in green have sat and passed the CFA Certificate in ESG Investing. Numbers in brackets represent years of relevant experience.

Active Management

We also believe in an active approach such that portfolios can dynamically allocate towards the most attractive opportunities over time, making the most of the various risk and return options provided by the structure of a typical securitisation (explained earlier). The additional credit enhancement put in place within certain tranches may provide for lower risk investments, whereas higher returns may be achievable by investing in the more subordinated tranches of the securitisation.

Given the current market backdrop, many economists are expecting a global economic contraction, which has led some investors to reduce risk within their portfolios by increasing the credit quality of their holdings. We believe having the flexibility to adjust allocations in this way should allow for more robust portfolio performance.

Our experience and dynamic investment style can be evidenced by our approach to Commercial Mortgage Backed Securities (CMBS) in the current environment. Whilst the CMBS market has recently come under pressure given where we are within the economic cycle, our exposures has been very selective.

We’ve focused on allocating to Single Asset Single Borrowers (SASB) - being focused within trophy/headquarter buildings, which are fit for purpose in today’s new hybrid work environment, as well as last mile distribution and logistics, life science properties and laboratory spaces as well as cell towers and the right type of retail.

We continue to watch the market closely and have exited deals without top tier sponsors and have actively avoided hotel and retail for many years.

A Global Approach

Our preference for active management and diversification applies to geographic asset allocation also, given the geographies of the most interesting opportunities within the Securitised Credit market adjusts over time. As shown in the chart below, the Securitised Credit market is indeed global, with the US a large component of the opportunity set. Together, the US and Australia account for over 80 per cent of the distributed market, whilst Europe and the UK account for around less than 20 per cent. The US market is also more diversified with all segments having large weights and typically offering superior liquidity.

Sources: HSBC Asset Management; AFME, SIFMA (data updated in May 2022 using latest available SIFMA data as at 31 Dec 2021); Australian Statistics Bureau; Reserve Bank of Australia and JPMorgan.

We therefore believe Securitised Credit investors focusing only on Europe could benefit from broadening the geographic reach of the portfolios and dynamically allocating. In particular, including the US may provide the following benefits:

• Better value and more attractive opportunities, given the European Central Bank’s intervention to reduce supply and artificially depress credit spreads
• Access to attractive, US-only segments such as Single-Family Rentals (SFRs)
• Improved diversification in general, leading to a more resilient portfolio, capable of delivering more consistent investment returns
• Fundamentally superior opportunities over the medium term, given the cost-of-living crisis, energy shortages and the geopolitical risks emanating from Eastern Europe

ESG Integration

Sustainable investing is a key consideration for investors and an integral part of our investment processes. However, Securitised Credit has lagged other markets in the development of clear ESG guidelines. As an example, Fitch estimates that only around 2 per cent of the market is directly impacted by ESG factors, and there are also no consistent third-party assessments of ESG risks. For this reason, at HSBC Asset management, we have developed a proprietary ESG scoring process in order to achieve our objective of ensuring ESG factors are sufficiently considered. The outcome of this part of our process is that certain transactions may be excluded from our funds. Typical examples rejections include Subprime Credit cards and Subprime Auto ABS, with the relatively high interest rates and Governance issues in their collection practices determining factors.

The Case for Securitised Credit Funds

Find out more about our Securitised Credit capabilities