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In this blog, we take a look at securitised credit, a potential solution to the LDI collateral pool conundrum. We also look at how, by diversifying the pool of liquid assets and limiting downside at the points when capital is needed the most, pension schemes are in a better position to meet margin calls. However, this requires investors to look past the fears that plagued the asset class in 2008, which mostly proved to be unfounded. In our opinion, this has created an opportunity for investors to buy bonds which are still trading at lower prices than they probably should be.
For pension schemes invested in liability driven investment solutions (LDI), where to invest the liquidity buffer to meet margin calls can be a challenge. These pension schemes especially, will need their assets to work hard and help close the funding gap. Holding cash or money market funds provides very little in return, holding gilts can be volatile, and the industry’s answer: ‘absolute return bond funds (an actively managed unconstrained approach), has experienced poor performance, making many investors question whether they are the right solution in isolation’.
What is securitised credit?
Securitised credit and asset backed securities (ABS), both of which can be used synonymously, describe a type of bond that is secured against a pool of loans with similar characteristics. The pool of loans will consist of hundreds or thousands of high quality loans, such as mortgages or small corporate loans. Examples consist of a traditional bond, investors benefit from income payments, and the principal is paid back at the end of the loan’s term. Since 2008, securitised credit has been subject to tighter regulation and stricter underweighting criteria, further benefiting the quality of loans which underline the bond.
What is it that makes securitised credit unique? Securitised credit assets are structured into different tranches and each has a different level of risk and return based on their position in the capital structure. For example, a securitised credit bond backed by a pool of residential mortgages in the UK (the mortgages we take to purchase our houses in the UK) will have higher and lower quality tranche options for investors. If borrowers are late with repayments, or stop repaying their mortgage completely, the higher quality tranches would be protected as the lower quality tranches take the initial losses. Meaning investors higher up the capital structure continue to receive their expected income and principle back at expiry.
"This has resulted in higher quality tranches (the area most suitable for pension schemes), which have had a very low default rate, even over stressed market periods such as 2008."
Global secured credit average annual default history (1976-2017):
|Original rating||Default rate|
Source: Insight Investment, Standard and Poor’s 2017 Annual Global Structured Finance Default Study and Rating Transitions 1976-2017 Moody’s Investor Services Default Report 1920-2017
The near non-existent default rate in investment grade tranches is helped by the bond being securitised against thousands of high quality loans, enhancing diversification. Also, due to demand from investors, the majority of securitised credit bonds offers a floating rate exposure to interest rates, meaning if interest rates rise, the bond will benefit as the income received will be higher. These characteristics, as well as daily liquidity, and a current yield of c2.5%, make the bonds attractive for many uses within a portfolio.
How can it be used within a portfolio?
Allocations to securitised credit have been growing in popularity amongst our defined benefit pension scheme clients when held alongside other asset classes such as, cash and absolute return bonds in an LDI solution (more information on LDI can be found here). In fact, we believe it excels because, over the past 3 and 5 years, securitised credit has demonstrated a negative correlation to gilts, lower volatility, and attractive returns.
Below shows the historic performance of securitised credit and gilts:
Source: Thomson Reuters, Monthly returns
During periods when gilts have fallen in price and yields have rallied, the performance of securitised credit has not been impacted, reducing the risks associated with selling at a negative return at the time when investors need to meet margin calls.
"Overall, securitised credit provides an attractive return to help close the funding gap, as well as being a way for schemes to diversify their collateral pool with good fundamentals underlying the bonds."
By diversifying the pool of liquid assets and limiting downside at the points when capital is needed the most, pension schemes are in a better position to meet margin calls, without impacting long term expected returns.