Continuing our exploration of the Benefits of being a Wholesale Client, our next edition highlights a sector of the market reserved for wholesale clients due to their non-standard nature – structured credit.
Previous articles were looking at credit ratings ( here) and FIIG-originated unrated primary issues ( here).
What is structured credit?
Most bonds are what is known as vanilla – i.e. they are a simple loan to the issuer that is available for their general corporate purposes, and enjoy the backing of the total assets of the issuer, depending on where in the capital structure they are issued from.
Structured credit is more complex, and typically involves a pooled group of assets backing the issuance of a tranched series of bonds from a Special Purpose Vehicle (“SPV” – usually a trust), with a strictly defined structure (hence the term ‘structured’ credit) describing the mechanism of payment of the returns from the bond, either principal or interest, and also incorporating potential losses.
The most common structured bonds in the Australian market are Residential Mortgage Backed Securities, or RMBS. Other securitisations can be structured using different types of assets as collateral, such as credit card receivables, personal loans, or other financing types such as invoice receivables.
We shall examine this sector of the market through the lens of RMBS, as they are the most common and most widely understood collateral backing bonds.
We covered the basics of RMBS in our article on the 11th of May, which can be found here.
Source: Wikipedia https://en.wikipedia.org/wiki/Mortgage-backed_security
Structured credit is restricted to sophisticated or wholesale investors due to its more complex nature – we will examine these aspects individually.
As mentioned above, the assets backing the issuance of structured credit are typically pooled collections of varying types of receivables, in this case, residential mortgages.
These assets generate 3 types of cash flows; principal, interest and losses; all of which have to be dealt with in the terms of the bonds issued from the SPV.
The order in which these three cash flows are paid out to bondholders is known as the payment waterfall, as each particular expense of the SPV has its own place in the waterfall as defined by the documentation.
Typically the waterfall has various trigger points whereby these cash flows are paid to one or another group of bondholders depending on the performance of the underlying pool of assets. Because of this, it is the performance of the pool as a whole that drives the individual outcomes of each of the tranched bonds issued by the SPV.
Therefore it is important to understand the important metrics of the pool and how that might affect the particular bond or tranche that has been invested in.
In the context of RMBS, the metrics that are typically focused on are the weighted average LVR, months of seasoning, CPR (repayment rate), subordination, arrears and losses and excess spread.
These are terms that are specific to the RMBS sector and therefore are considered more complex than the more usual fundamental metrics that one might look at in a company, such as the gearing ratio, which would not necessarily apply to a structured situation.
The characteristics of the particular asset type in the pool are important to understand, as while a pool of residential mortgages may have similar seasoning or CPR to a pool of personal loan receivables, the required subordination to achieve a particular rating level might be very different given the relative risk of the underlying assets.
The risk/reward of a particular tranche of the bonds available from a structured credit transaction is available given the relevant metrics associated with the particular tranche.
Typically this is reflected in the rating of a particular tranche – remembering ratings are only available to wholesale clients – as they are designed by the rating agencies to allow an equivalency of risk across similarly rated tranches from different transactions.
Understanding the relative risk and return of a particular tranche in a given transaction and also across the wider market requires a deeper level of understanding given the complexity of the cash flows and variability of the same, driven by the unpredictability of the cash flows from the underlying assets and the assumptions that are embedded into the pricing of these transactions.
The subordination, CPR rates and associated capital returns if triggers are met and underlying market rate assumptions all contribute to the returns from a particular bond.
The inherent uncertainty from this range of inputs into the return calculation is one of the major determinants of the complexity of these securities when compared to vanilla bonds, which typically only have a single variable (assuming they are fully repaid) if they are floating rate (BBSW) or inflation-linked (CPI). Fixed rate bonds are even simpler given the return if held to maturity is fixed at the time of purchase.
In conclusion, it should be clear that there is a significant amount of complexity involved in structured credit compared to vanilla bonds, which is why they are restricted to wholesale qualified or sophisticated investors.