Opportunities in investment-grade securitised credit

The roundtable – chaired by PP editor Jonathan Stapleton and held in association with TCW – asked why this remains an underinvested asset class in the UK and looks at the potential benefits it can offer pension scheme investors.

Can I ask for your perspective on where the securitised market is now and for some opening thoughts please?

Peter Van Gelderen (TCW): The global securitised market currently stands at around £10trn. In the United States, government-guaranteed mortgages (agency mortgage-backed securities) are priced at some of their most attractive levels in decades. Commercial mortgages, specifically office properties after the COVID pandemic, are exhibiting dislocation and creating selective opportunities for active asset managers like TCW. Looking at issuance volumes, European securitised still trails the U.S. and accounts for less 5% of the global market. However, Europe is increasingly embracing securitised with new issuance volumes 50% higher than the previous year. In Australia, new issuance has surged by 160% compared with the previous year. 

Europe is starting to show signs of continued maturation and growth, albeit with some dislocations. We are seeing positive signals in the global sentiment towards securitised credit, as markets in the UK and Europe begin to acknowledge that this asset class has evolved significantly since the Global Financial Crisis (GFC) of 2008-2009.

Malea Figgins (TCW): Historically, the asset class has been excluded from sustainability discussions mostly due to concerns about data availability. Five years ago, the market was only focused on exclusionary criteria in collateralized loan obligations (CLOs). We have come a long way since then – integrating sustainability considerations into our securitised credit research and investment process by analysing the underlying collateral and targeting investments that offer good relative value and have positive environmental and/or social characteristics. We have dedicated considerable effort to building out processes and analytics that allow us to identify opportunities in sustainable security selection and integrate risk factors that were not part of the traditional investment process, such as climate physical risk and transition risk. This approach not only enhances our ability to invest sustainability but also helps to mitigate risk and can lead to improved long-term risk-adjusted returns.

Janet Oram (USS Investment Management): Peter, you said that, from a US perspective, securitised is not the same as it was in 2008 and 2009. I think it is important to draw a distinction between what happened in the US in 2008 and what happened here in Europe. With the exception of commercial mortgage-backed securities (CMBS), which had issues in part because of loans made on commercial properties at the peak of the market, there were few credit issues within the European securitised market. Clearly there were pricing issues because "everyone" thought, ‘I don't want securitisation exposure', but from a credit perspective, there were very few issues in the European market.

Peter Van Gelderen: Approaching US markets with the same trepidation as 2008-2009 financial crisis ignores the significant improvements in underwriting and credit quality, driven by regulation, that are in place today. The issues were primarily located in subprime residential mortgages, and to some extent, commercial mortgages. However, US securitised is still penalized 15 years after the fact based on what happened in those two subsectors and doesn't take into account the rigorous underwriting that is now in place which in no way resembles what it during the GFC. Since the GFC, no CLOs rated AAA or AA have taken a dollar of loss. Similarly, sectors of asset-backed securities (ABS), including esoterics, largely remained unscathed.

What can securitised add to a pension scheme portfolio?

Hanna Wan (WTW): People rightly point out diversification due to the asset class giving you access to areas such as consumer risk and real estate like residential and commercial, that diversify away from the typical corporate holding. Historically, the spread has always been relatively wider than similarly rated corporates, so you get that pickup.

Today, you are still starting at a higher yield as well. This is an asset class that is relatively under-invested, possibly to some extent due to it being marred by what happened during the Global Financial Crisis (GFC). It is about education around the differences between, say, the US and European securitised markets and what subsectors are underneath.

Do you agree there still a hangover in perceptions from 2008 and 2009?

Emma Coleman (XPS Pensions Group): These perceptions are at the forefront of people's minds. But I look at it from the perspective of what pension schemes need it for and what they are looking to do now – which is, primarily, to allocate to high-quality credit, but I also observe pension schemes making large allocations to long-dated-, sterling, investment grade‑ corporate bonds, which is a more concentrated market with a very small number of issuers.

For us, securitised credit is a vital part of widening your opportunity set because schemes need a liquid diversified credit allocation. We think it is not always as simple as 50% in liability driven investment (LDI) and 50% in sterling investment-grade corporates. There is more that schemes can do, but there is the generic term of liquid diversified credit. What does that mean? That is where the education point certainly comes in.

There is a hangover in that there is a wider educational point about the role credit can play in pension scheme portfolios in the medium to long term.

Alan Pickering (BESTrustees): I rely on my advisor to tell me whether it is the right asset class and warn me against the downside. Even if one forgets 2008, there is danger of contagion in the market because you do not know who your fellow investors might be. They might not be the most salubrious people or they might be salubrious but have different priorities.

Jonathan Craddock (Van Lanschot Kempen Investment Management): It also depends on the implementation you use. If you use an investment consultant, you take it to the trustees and explain everything. Under a fiduciary arrangement, that decision-making is delegated to the fiduciary manager, then it is more around training. You put it in their portfolio because it is the right thing to do, but the trustees also need to be aware of what is in their portfolio.

How are you approaching securitised?

Janet Oram: When I joined USS, it had no direct asset‑backed securities investment and one opening statement was ‘Is this not what caused the 2008 financial crisis?'

The mandate was initially set up with very specific concentration limits that, in the absence of a suitable benchmark, made sure it looked like the broader market (such as a minimum of 75% triple A). I was very clear that it would take 18 months to ramp the investments, which is not necessarily what you would expect, but we wanted to do it carefully.

We also needed to prove that the internal "plumbing" worked and that we could tick all the regulatory boxes. On an absolute basis we have outperformed a number of other mandates: in large part because this is a floating rate asset class and there has been interest rate volatility.

Lynne Stewart-Brindle (PAN Trustees): For me, with my DB pensions background, I am heavily led by the investment consultants' appetite for an investment, whether it is private equity or asset-backed securities. It is hard for managers to tell buyers to not worry about 2008 and it is a big ask to get over that perception and rebuild confidence. I remain sceptical because, while I can understand equities, for instance, I do not think I will ever have that same clarity with asset-backed securities.

Alex Lennon-Smith (TCW): At the moment, it feels as though consultants are more comfortable with securitised than trustees. With investment-grade corporate spreads close to all-time tights, the opportunity set in that space is limited. Given the demand driven by the pension risk transfer market expansion following the broad improvement in pension funding status, IG corporates represent too small a market to absorb those flows. As a result, it's prudent to look at other investment-grade credit assets to ensure pension holders are invested in well diversified portfolios that maximize risk-adjusted returns. As of today, the TCW Global Securitised Credit fund offers a targeted spread of 150-200bps, compared with around 80bps in IG corporate credit. The underinvestment in securitised credit creates a timely opportunity, but getting trustees comfortable with that investment is still a significant barrier that requires additional education by all market participants, representing a great example of how the industry can collaborate to achieve better outcomes.

What is the liquidity of securitised if pension schemes need to liquidate their holdings?

Emma Coleman: The gilts crisis was an acid test for securitised credit as clients had allocations and needed liquidity as quickly as we could get it. It passed that test because we had clients invested in predominantly investment grade daily or weekly traded funds, and they were all able to meet those redemptions. There were higher dealing costs, but they were relatively muted in comparison to other types of credit. I did learn that the impact of outflows on a fund can be more pronounced when you have funds or products that are set up with solely DB investor pools.

Hanna Wan: It is fairly liquid for high-grade. In the gilts crisis, all the liquidity that was needed was fulfilled, i.e. bonds were traded, albeit at prices you would expect in times of market stress. The advantage of securitised is you can pick and choose the risk and return profile as well as the duration and exactly what you would be comfortable with. If you look at the tranches, you have roughly 60% triple A, then the lower tranches are thinner and therefore much less liquid.

Emma Coleman: It is about risk. The risk of allocating to ABS is around the complexity, contagion risk and lack of understanding of underlying collateral pools of the underlying assets and the contagion risk if a fund is too concentrated. However, this should also be compared with the concentration risk of retaining a credit portfolio which is solely invested in Sterling investment grade credit, and the impact this can have on liquidity.

Peter Van Gelderen: When thinking about liquidity across various geographies and various sectors, it is important to consider the portfolio as a whole. No individual security is going to be immune from liquidity constraints, defaults, or idiosyncratic risks. The LDI crisis was a geographically specific issue to EU/UK. It was not a crisis in the US. So, when liquidity was needed to offload assets, the trade investors went to the US to access liquidity. Likewise, there are US events that don't affect UK.

The solution is to create a well-diversified global portfolio that is not subject to any one of these risks so that, if an individual investor needs liquidity at any given time, the portfolio can accommodate that demand. You want to create something where, under any market condition or any geographic stress, your client is not going to be surprised by the return or liquidity contour that they originally agreed upon.

How are you allocating globally? Where do you see specific opportunities?

Peter Van Gelderen: The largest, most liquid, most creditworthy securitised asset class is government guaranteed residential mortgages. This is a £7trn market with spreads at plus 140-150bps, offers excellent liquidity, addresses credit concerns and is, in our view, one of the most attractive areas in the current market.

We've also observed a healthy shift in client behaviour in the current rate environment: clients who were previously seeking more aggressive return profiles are now opting for a more conservative approach. This provides an opportunity to offer investment products that focus on steady, reliable returns without taking on excessive risk. It is our responsibility to provide a client-driven investment product that offers compelling return for the risk you are taking by investing in securities that meet that need while maintaining a healthy mix of liquidity and credit quality.

Jonathan Craddock: If I have a client targeting gilts plus 1%, it is likely to invest in the investment grade area of securitised credit, with a small allocation of around 5%. For clients with return targets of gilts plus 2.5% and above, rather than investment grade securitised credit, it is more likely they are going to invest in the sub-investment grade area of the market because they need the extra returns.

Should investors have concerns over credit risk within securitised?

Peter Van Gelderen: Securitised credit has proven to be a useful tool for portfolio diversification and returns over time. However, it cannot be understated how damaging the performance of certain sub sectors have had on investor appetite following the Global Financial Crisis.

Painting securitised with a broad brush ignores how diverse the underlying collateral is and the different liquidity, credit, risk and return profiles available within the capital structure.

Asset owners don't voice concerns about corporate credit because they understand what a company is, but the truth is companies default every day. There has never been a more concentrated environment where lenders are competing fiercely and getting idiosyncratic outcomes. Meanwhile, there are ABS sectors like cell towers, data centres, and residential housing that have never performed better. There are so many different sectors that each offers compelling opportunities for securitised credit investors, but you don't have to own all of them. 

Yet financial problems are not isolated to securitised credit only. If you look at corporate credit 25 years ago, cable providers also had problems. Credit investing also involves risk that you cannot entirely mitigate, but with careful active management you create diversity to avoid the impact of a problem, whether it is through liquidity or credit.

How can sustainability be integrated into securitised portfolios?

Malea Figgins: Despite some misconceptions in the market, we think the asset class naturally lends itself to sustainability due to the asset-backed nature of the product where we can look to the underlying loans and assets and review any available environmental or social-related data. This is much more tangible than a green corporate bond where the proceeds are used for "general corporate purposes."   

For example, in UK residential mortgages, we can look to energy performance certificates (EPCs) as a tangible metric for energy efficiency. Understanding that there is still work to do in collecting EPC data more broadly, and normalizing EPC ratings across the EU, this creates an opportunity for us to engage and collaborate with industry groups, issuers, and regulatory bodies.

In the agency residential mortgage-backed security market, each of the government-sponsored enterprises (GSEs) publish an "Equitable Finance Housing Plan" that outlines how agency-backed lending helps to provide equitable access to homeownership, particularly for underserved borrowers and communities in the U.S. Recently the GSEs published a Mission Index that provides investors with additional social-related data to target pools with a strong affordability component.

Janet Oram: This is interesting for securitised at a philosophical level because there could be two RMBS pools where in one, every property underlying the mortgage has an EPC of A and is low emission; the other more representative of the wider housing stock. If we prefer (and therefore fund more cheaply) the first transaction, we potentially just gave wealthier people a cheap mortgage because they had a green property and made the mortgages more expensive for the lower socioeconomic groups who can only afford to live in the poorer quality housing. What we need to do, which is where securitised should play a part, is help finance the retrofitting of those other properties.

Lynne Stewart Brindle: I do not have confidence in any data on this asset class regarding sustainability because it is too complicated for the myriads of different investments behind it to actually get the data.

Emma Coleman: The sustainability aspect is one of the biggest challenges and opportunities for us, and it is an area where I would like to be convinced of the suitability of securitised credit. I have found it can be hard to robustly integrate sustainability in the same way as other types of credit because of the philosophical point around what data point you pick and whether is it relevant. Also, EPC certificates feel like the easy one. What about consumer loans? You do not know what the proceeds of loans will be.

When we give an ESG rating, it is not just data and carbon emissions, it is ESG integration, stewardship and engagement with originators. There are also exclusions, which can be difficult for securitised mandates to fulfil because if you have CLOs, where you are actively switching loans in and out of a pool, and it is more difficult to consistently apply exclusions.

Peter Van Gelderen: The key to integrating sustainability considerations into securitisation is data transparency. Within securitised, if you do not have clear, reliable data on the underlying attribute used to identify a sustainable dimension, then you do not have anything. Our approach focuses on ensuring transparency of the underlying data. The data must exist to support any sustainability claim.

Lynne Stewart Brindle: I am somewhat cynical, and I have general cynicism about data from any asset class on sustainability. There were many lessons learned from the LDI crisis, which in hindsight seemed obvious. Although some of my schemes do invest in securitised, I am more nervous about this asset class because you have this black hole of unknowns. I can hear the echo of somebody in the future saying, ‘lessons learned'.

Janet Oram: I am concerned that you think there is a black hole in terms of data. When I buy an RMBS transaction, I have a loan tape with information on every single mortgage in the transaction, including things like the geographic location and the income of that borrower. You can't see that detail on the loans sitting on the balance sheet of a bank whose corporate bonds you buy.

Hanna Wan: When Russia-Ukraine happened, and in terms of aircraft ABS, we could find out what percentage of the aircraft was linked to Russia within the next day. It is not a black hole, but it is about the volume of data – there is a lot to sift through.

Alex Lennon Smith: There is certainly an element of scepticism about sustainability from boards and trustees. Instead of having a binary view of what qualifies as a sustainable investment, we think it's important to take a measured, humble approach and make small but consistent marginal gains. Today, we can give you some real sustainable investments in securitised credit, but it won't be for the entirety of the portfolio. We are going to battle every day for our clients and tomorrow we are going to deliver more than yesterday. Most importantly, it is crucial that as an industry we are transparent about what datasets are available today and the work we are undertaking to achieve better outcomes tomorrow. Data will continue to play a central role in both the challenge and the solution to integrating sustainability into investments.

What are your key takeaways or concluding comments from this discussion?

Janet Oram: The biggest reason for underinvestment in securitised is lack of understanding, because there are a lot of misconceptions. There is also the perception it sits in the ‘too hard bucket' – actually, I really don't think this should be the case.

Alex Lennon Smith: There is a growing need to get comfortable with securitised credit as defined benefit (DB) schemes are showing more demand for liquid IG investments following the rapid improvement of funding status. It's a challenge, but it is one that requires collaborative effort across the entire investment chain, from managers and consultants to pension trustees and end clients. A significant part of this process involves education that comes from managers working closely with the consultants by sharing market research and developments. Ultimately, I do not think this is an asset class that can be ignored if you want to follow the Prudent Investor Rule and build the optimal portfolio for clients. It is something that we all need to get more comfortable with.

Emma Coleman: Securitised credit has a very important use case for DB schemes, primarily as LDI collateral, but also for diversification and return pickup. Investment advisors have an important role to play in the education, but also in the examining of mandates to understand things like challenges around sustainability. Things like management fees are another important aspect for scheme governance. I think securitised credit has a vital role to play in this widespread derisking that we are going to see, but it needs to be approached with careful due diligence and independent examination.

Hanna Wan: I agree on the lack of education and understanding. In terms of the use of securitised credit, it is gaining more and more traction. More people are getting more familiar with the terms, but there is still nervousness around allocating a high proportion of your portfolio to it.

Education is very important – not just in terms of what securitised is, but what is underneath it as well, like ABS or RMBS, and the nuances among the sub-sectors. Also, if you think about it, for some UK and European investors, we talk about the global securitised market, but what is actually available for UK and European investors is only a portion of that because it needs to be EU regulation‑compliant. It is quite hard to aggregate all of this into a single slide for a trustee meeting.

It is such a diverse asset class. The subsectors are just so different. But it does offer investors the opportunity to pick and choose what kind of risk and return profile they like, and then they can also pick the tranche and the exposure that they like.

Jonathan Craddock: I will probably reiterate my comments from earlier. Securitised credit does play a part in a diversified portfolio, and it has a value. The amount that you allocate and actually the type that you invest into very much depends on scheme specific circumstances and characteristics. If you are targeting a low level of return, you are not going to go into sub-investment grade, conversely, if you need a really high level of return, potentially you are going to go for the sub-investment grade part.

Alan Pickering: Around this table, we are all on the spectrum between the end users of the money that we are stewarding. On one end are the commercial users of these assets, and at the other end are the beneficiaries who rely on us for later‑life security. The sort of engagement that we have had today should be the sort of engagement that everybody in that food chain has. That sort of engagement is important, particularly when it comes to building understanding of these assets, which I think have a role to play in both DB and DC in different sets of circumstances.

Lynne Stewart‑Brindle: I do support the asset class and do invest in this asset class with a number of my portfolios.

Whether other trustees, users and I should be doing more of that or increasing the proportion will come down to the education and confidence building so that we can be more confident in what we are investing in, and we can bust the myths of the past.

Malea Figgins: Sustainability is a journey, but you have to start somewhere. Sustainability should always be rooted in transparency and intentionality. And you need a manager who is committed both. A fully integrated approach for sustainable security selection means underwriting each credit through both a relative value lens and a sustainability lens. We use the best available data to inform those decisions, then leverage our engagement to acquire and improve the data when it isn't available.

Peter Van Gelderen: This has been a valuable discussion. I would say that, over the course of my career, I've learned that the key to gaining the trust of my team and my investor base is to listen first and then roll up my sleeves and do the work - not being afraid that something is new or challenging. In the case of securitised, it is about adopting the same approach.

Ultimately, having someone that you can trust and having someone that is willing to do the work and provide the rationale and understanding of how they came to the conclusion they came to, is the first step to adopting something.

It's about understanding that new asset classes might have dimensions that are uncomfortable or that take some education to fully understand. But this the first step in identifying something that in the future will be a valuable contributor to your overall performance.

This roundtable was held on 5 November 2024 in association with TCW