Are Structured Products and Complex Credit Assets the Phoenix of the Financial Crisis?
As the Roman epic poet Virgil wrote in the Aeneid, “Fortune favors the brave.” For investors who live by this creed, complex credit assets and structured investments — once the scourge of global financial markets — are beginning to regain some of their appeal and may offer compelling opportunities in the current economic and financial environment, according to portfolio managers Michael Lustig of BlackRock, Inc. and Lindsay Holtz, CFA, of Diversified Global Asset Management (pictured left).
Both practitioners outlined their views in separate sessions at the CFA Institute Global Fixed Income Management Conference in Toronto earlier this month. The crux of their argument: As yields on traditional fixed-income investments have declined and credit spreads have narrowed, structured products and complex credit assets are offering attractive risk-adjusted returns.
Holtz calls credit assets — such as credit relative value, loan pools, mortgage derivatives, credit sensitive asset-based securities, and private lending — “complex” because of their structure, transparency, the due diligence required, and valuation tax. These types of assets do not fit traditional long mandates because of their lack, or sometimes absence, of liquidity. However, these investments can increase the diversification of a broad portfolio because their correlation to equities, hedge funds, and other alternative assets is low. As a result, complex credit assets are often viewed as a separate asset class.
As spreads in liquid credit markets have declined over the past 18 months, according to Holtz, returns in the low- to mid-teens can be earned on a portfolio of complex assets. However, these returns do not come without risks, including liquidity and complexity risk, idiosyncratic credit risk, government and regulatory risk, and prepayment risk, to name just a few.
Structured products such as mortgage-backed securities (RMBS, CMBS), collateralized mortgage obligations (CMOs), asset-backed securities, and credit default swaps can also be viewed as complex credit assets; however, in most cases they are more liquid. Instead of creating or eliminating risk, however, structured products transfer risk in a hierarchical manner so that a credit asset can be tailored to meet the risk and return objectives of different investors.
According to Lustig, collateralized mortgage-backed securities (CMBS) are making a “comeback” because of better underwriting standards, greater credit cushions, and more issuer-retained risk. For example, a loss buffer, or subordination, has been built into AAA-rated classes to give investors better protection. In addition, commercial loan pools are more diversified by geography, property type, borrowers, and tenant exposure, making them even less susceptible to credit event risk than corporate bonds.
Lustig suggests that investors who are interested in structured products such as CMBS should place greater emphasis on credit analysis, security structure analysis, and relative valuation analysis before as well as after investing in these instruments. After all, fortune may favor the brave, but it rarely casts sunshine on those who don’t do the legwork.