What is Structured Credit: A Guide to Fixed Income Investing

Definition and Overview

Structured credit is a type of financial instrument that typically involves investments backed by assets. These investments often have a fixed interest rate, referred to as a “coupon rate,” and are grouped into different risk categories to cater to varying investor needs.

Structured credit is becoming more popular among institutional investors who want to change their portfolios because of rising interest rates. By grouping different assets, like mortgages or loans, structured finance vehicles give investors a way to diversify their holdings and attain a steady cash flow.

The Rise of Structured Credit

In recent years, more and more institutional investors have been interested in structured credit solutions. There are a few reasons for this trend. One reason is that investors are seeking higher returns in a low-interest-rate environment. But even when interest rates are higher, investors are always seeking ways to diversify their portfolios beyond traditional fixed income securities.

As investors try to deal with the challenges of rising rates and market changes, structured credit has become an attractive option for those looking to balance risk and return.

Key Takeaways

• Structured credit investments pool and tranche underlying assets, offering investors various risk and return profiles while employing credit enhancement techniques to mitigate risk.

• Commercial mortgage-backed securities (CMBS) and residential mortgage-backed securities (RMBS), asset-backed securities (ABS), and collateralized debt obligations (CDOs) are popular structured credit options, providing diversification, regular cash flows, and potential for attractive risk-adjusted returns.

• Institutional investors should collaborate with experienced managers and adopt a multi-asset class approach when incorporating structured credit into their portfolios, while being aware of the associated credit, interest rate, and liquidity risks.

How Structured Credit Works

Pooling and Tranching

At the core of structured credit lies the process of pooling and tranching. In this approach, various assets, such as mortgages, loans, or other receivables, are bundled together into a single investment vehicle.

These underlying assets are then divided into different tranches, each with its own risk profile and potential return. By creating these distinct risk categories, structured credit allows investors to choose the level of risk and return that aligns with their investment objectives and risk tolerance.

Credit Enhancement and Risk Management

To mitigate the risks associated with structured credit investments, various credit enhancement techniques are employed. These may include over-collateralization, where the value of the underlying assets exceeds the value of the issued securities, or subordination, where certain tranches are designed to absorb losses before others.

Additionally, risk management strategies, such as credit default swaps, can be used to transfer credit risk to other parties and protect investors from potential defaults.

Types of Structured Credit Investments

Mortgage-Backed Securities

One of the most well-known types of structured credit investments is mortgage-backed securities (MBS). These securities are made by grouping together mortgages, which can be either residential real estate (RMBS) or commercial real estate (CMBS).

The payments from the underlying mortgages are distributed to investors based on the specific tranches they hold. In recent years, both RMBS and CMBS have seen positive trends, driven by improvements in the housing market and rising property values.

Other Structured Finance Options

In addition to mortgage-backed securities, structured credit also includes asset-backed securities (ABS) and collateralized debt obligations (CDOs).

ABS are made by grouping together different types of assets, such as car loans, credit card debt, or student loans.

CDOs, on the other hand, are structured credit vehicles that pool together a diverse range of debt obligations, including corporate bonds, loans, and even other structured finance products.

These vehicles give investors the chance to gain exposure to specific sectors or asset classes while potentially benefiting from diversification and risk management.

Structured Credit Benefits and Risks

Advantages of Structured Credit

Structured credit investments offer several benefits for institutional investors, including the potential for diversification, as these investments allow returns to be tied to specific assets rather than general corporate credit.

Additionally, structured finance products can provide a regular stream of cash flow, making them an attractive option for investors seeking a steady income. The use of risk management techniques also helps to manage risk and protect investors from potential losses.

Risks and Challenges

While structured credit investments offer many benefits, they also come with certain risks and challenges.

Credit risk is a primary concern because the performance of these investments is directly linked to the ability of the underlying borrowers to make payments.

Interest rate risk is another factor to consider, as changes in interest rates can impact the value and cash flows of structured credit securities.

Liquidity risk is also present, as some structured finance products may have limited secondary markets, making it difficult for investors to sell their positions.

Getting Started with Structured Credit

Structured Finance Strategies

For institutional investors looking to add structured credit to their portfolios, a multi-asset class approach can be effective. By diversifying across different types of structured finance products, such as RMBS, CMBS, ABS, and CDOs, investors can potentially increase returns while managing risk.

Additionally, careful selection of investments with strong fundamentals within each sector can help to optimize the risk-return profile of a structured credit portfolio.

Working with an Investment Manager

Given the complexity of structured credit investments, it is important for institutional investors to work with experienced investment managers who have a deep understanding of these instruments. A skilled investment manager can help to navigate the complexities of structured finance, identify attractive opportunities, and build a well-diversified portfolio aligned with an investor's specific goals and risk tolerance.

When evaluating potential investment managers, investors should look for those with a proven track record of success in the structured credit space and a commitment to transparency and risk management.

Conclusion

Structured credit gives institutional investors a unique opportunity to diversify their fixed income portfolios and potentially generate attractive risk-adjusted returns. By understanding how structured finance works, including the grouping and dividing of assets and the use of risk management techniques, investors can make informed decisions about whether these investments align with their goals.

While structured credit investments come with certain risks, a well-designed strategy implemented by a skilled investment manager can help mitigate these challenges and unlock the benefits of this dynamic sector of the fixed income market.