Views from the LDI desk – November 2023

Collateral waterfalls – the role of securitised assets

Over the course of 2023, pension schemes have continued to work with their advisors and LDI managers to evolve collateral resilience to market shocks and to determine pre-identified strategies for how assets should be sourced to meet collateral requirements. This is often referred to as a “collateral waterfall”.

Alongside reviewing the roles and responsibilities with respect to management of collateral waterfalls, we believe collateral resilience can be enhanced by diversifying the assets* that are part of the waterfall as well as deploying tools such as credit repo and credit collateralised gilt repo.

We have seen schemes exploring a variety of assets to build their collateral waterfalls, but typically favouring more liquid forms of credit such as corporate bonds, short-duration credit, and securitised assets.

In this piece we focus on securitised assets and explore the benefits they can bring alongside the more traditional buy and maintain credit allocations many schemes now hold.

The benefits of Securitised Assets

For pension schemes looking to diversify their collateral waterfall, we see three key benefits:

• Relative value: access to higher or similar yields to corporate bonds but with a higher rating profile. The European securitised market is relatively unique in that most assets are rated AAA, (~85%¹ of distributed issuance year to date) and yet can also provide yields of 6-7%² in sterling terms. To achieve comparable yields in corporate bonds today one would need to invest in A or BBB rated assets.
• Diversification: the securitised market is incredibly diverse across sectors and geographies. It provides exposure to consumer assets away from direct corporate or sovereign risk. For some transactions, investors also have access to a range of rated notes across the capital structure 
• Duration protection: as the securitised market is predominantly floating rate with coupons typically linked to either SONIA or EURIBOR, clients are not exposed to interest rate risk in the same way they are in alternatives. Clients can potentially gain and manage this risk more efficiently through their LDI exposure.

Chart 1: Securitised Assets offer a yield premium vs Corporates

Before diving deeper into some of these benefits and use cases, for those less familiar with the asset class, we address what securitised assets are.

What are securitised assets?

Securitised assets are bonds secured against a pool of loans with similar characteristics. They are structured into different tranches, and each has a different level of risk and return based on where they rank in the capital structure. Unlike the corporate bond market where issuers tend to have far fewer rating options, securitised issuers typically offer anything from AAA all the way down to high yield like assets rated BB/B, or even not rated at all.

Quality and liquidity are both key considerations for schemes when considering allocations in their collateral waterfalls. In BlackRock’s view, it is those assets at or close to the top of the capital structure, which are typically rated AAA or AA, that are most suitable. These are typically the most protected from a capital preservation point of view and, given the large volume of issuance and number of investors participating in this space, tend to offer more liquidity versus those further down the capital stack.

When discussing European securitised assets with potential clients new to the asset class, there can be a common misconception regarding historical performance. Losses have in fact been extremely low to non-existent for investment grade tranches in Europe. Furthermore, during the Global Financial Crisis, structures and mechanisms were tested in some transactions and proved to work. A clear example is the failure of Northern Rock; it originated and securitised large volumes of mortgages, and whilst the transactions were not immune to mark to market moves, they continued to operate even when the originating bank failed.

Chart 2 – Estimated multi-year cumulative loss rates by original rating for EMEA ABS, CMBS and RMBS. 2009 - 2022

Ring fencing assets in bankruptcy remote structures allows access to consumer credit risk away from corporate or sovereign risk. The wide range of geographies, sectors, asset types, structures and ratings mean that investors have access to a diverse set of potential investment opportunities.

Chart 3 – Diversification of European securitised assets by sector and geography

Within each sector, the asset types, and risk, can differ considerably – for example in Commercial Mortgage Backed Securities (CMBS) investors can gain exposure to office or logistics, in consumer assets, they can get exposure to Auto loans or credit cards and in the Collateralised Loan Obligation (CLO) space, a wide range of manager types. Even within each sub-sector, the structure and investor protection mechanisms in place can differ allowing investors to determine those securities that meet their requirements.

Market backdrop and the importance of fundamental research

During 2023, despite a worsening economic picture, securitised assets have performed well so far with only mild signs of deterioration in certain pockets of the market and significant spread tightening across the major asset classes year to date.

We have seen an increase in dispersion between sectors, individual securities, and parts of the capital structure. The magnitude of the pricing difference across the capital structure is currently particularly noteworthy for European securitised assets giving investors the opportunity to seek differentiated returns depending on their risk appetite compared to both the corporate credit and US securitised market where pricing overall appears more compressed.

Chart 4 – Securitised assets offer a spread pick up to equivalent rated Corporates

Each asset class has its own considerations. For example, within Residential Mortgage Backed Securities (RMBS), we see signs of delinquencies increasing predominately in old ‘legacy’ transactions backed by non-prime floating-rate loans originated prior to the global financial crisis, which now make up a small part of the UK mortgage market. Within CMBS idiosyncratic risks exist in the market, particularly in sectors such as retail and office, but risk dynamics remain asset specific.

Fundamental research has been the cornerstone of BlackRock’s Securitised teams’ investment process over the many years the team have been investing in the market. Regulatory requirements following the global financial crisis have also raised the bar for transparency and disclosure market wide, giving securitised investors a level of transparency and disclosure not typically seen in other fixed income markets. Loan level data supports detailed analysis and modelling of metrics such as arrears and defaults allowing investors to combine their own market, sector and asset specific stresses, applied at time of purchase and on an ongoing basis.

Continuously assessing macro-economic factors alongside deal performance and market knowledge to re-underwrite the stresses applied and determine portfolio appropriateness is key.

How do securitised assets fit into the collateral waterfall?

It is no secret that the European securitised market at €480bn³ outstanding is considerably smaller than both its US securitised counterpart and the investment grade corporate bond market. However, whilst not competitive in terms of volumes, it can be an effective source of liquidity. As is the case in most markets, there is huge dispersion in liquidity depending upon geography, sector, and rating. Other potential influencing factors include the eligibility of the asset for central bank funding schemes and/or the bank or insurance company capital charges associated with owning the security.

The assessment of the perceived liquidity of an asset forms an important part of BlackRock’s investment process. We look to ensure that we match investment opportunities to client’s liquidity needs. Additionally, we compare to alternative markets to ensure we are being compensated appropriately for the asset’s expected liquidity.

In periods of extreme market uncertainty and/or stress, the liquidity of the securitised market, as is the case with most markets, will be somewhat dependent upon the type of stress. The gilt crisis at the back end of 2022 was deemed to be a liquidity stress event as opposed to a credit one. During this spell UK DB pension schemes with LDI strategies in place required liquidity to meet their collateral calls as Gilt yields spiked aggressively higher. Large volumes of securitised assets were sold, demonstrating their liquidity and – capital preservation during this time.

As already highlighted, the securitised market is predominantly floating rate in nature which means it carries very little interest rate risk sensitivity. As the large mark to market drawdowns at that time were largely driven by rate moves the product was relatively protected resulting in potentially more limited price depreciation and related capital loss.

We saw multiples of the volumes we would typically see traded in the European securitised market during this time as can be seen in Chart 5 below. Bid wanted in competition (BWICs) volumes are one way for us to monitor trading activity in the secondary market. The BWIC process involves investors sending a list of bonds they wish to sell at a set time and date inviting market participants to bid. In addition to those assets sold via BWIC, our understanding is that the volume of bilateral trades also increased considerably.

Chart 5 – Significant selling of securitised assets during the gilt crisis

On the whole, the ability to trade securitised assets held up during the 2022 Gilt Crisis, spreads did move wider for a short period (see the 2yr peaks in chart 4 above) and transaction costs would have been somewhat elevated. This highlights that while securitised assets have an important role to play in the collateral waterfall, having other tools such as credit repo or credit collateralised gilt repo available to your LDI manager can potentially reduce the need to immediately sell assets at stressed levels.

As well as managing collateral waterfalls, many schemes are focussed on how sustainability can be integrated into their investment strategy. Unlike the corporate credit market which uses a range of data providers such as MSCI, there are no external sustainability rating providers for securitised assets. However, ESG considerations form part of BlackRock’s securitised investment process where data is obtained from multiple sources including transaction prospectuses, loan tapes and issuer meetings (engagement). An ESG assessment of the investment is made and BlackRock’s proprietary PEXT/NEXT™ externalities framework applied. This allows for ESG transparency at the asset and portfolio level and even allows for portfolios to be skewed to clients ESG needs.

The opportunity ahead

Securitised assets may offer an array of benefits including an attractive yield pick up to other fixed income sectors, diversification, exposure to floating rates and strong liquidity attributes. As we look forward, we expect to see further mild deterioration in credit performance of the European securitised market but for it to remain within our base case assumptions. We expect dispersion between the performance of securities to increase as we move through periods of stress and thus, as always, security selection remains of paramount importance.

If you would like to discuss further how securitised assets could fit into your collateral waterfall or find out more about the asset class, please reach out to your usual BlackRock representative.