Navigating the Securitized Credit Market | Webinar

Sid Chhabra: Good afternoon, everyone. Thank you for joining. My name is Sid Chhabra. I'm a Senior PM and Head of Securitized Credit and CLO Platform here at RBC. I'm also joined by Lucy and Tom from the team. We're very pleased to have you with us for this discussion, for this presentation, amidst a backdrop which is quite uncertain. Investors, clients, and allocators are deeply focused on making their portfolios more resilient, are really looking for solutions that can help navigate these market conditions, which are, as I mentioned, facing a lot of challenges.

We believe securitized credit can offer this key strategic allocation for our investors as they think about portfolio construction and look at their portfolios in depth. The market backdrop seems this uncertain because there is a lot of change. There is a lot of disruption. There's a lot of dispersion. This is on the back of a few different market forces, all impacting the environment around us at the same time.

To begin with, AI. The developments we've seen in AI space, the tools, the implementation of the tools is advancing quite rapidly. We expect businesses and consumers to use these tools a lot more going forward. That will change how businesses operate. Associated with these developments we've seen in AI and the advancements that we are yet to see, there will be a lot of issuance in markets. This issuance will come both in public markets, in private markets, in debt, and in equity.

Alongside this high level of issuance that we've seen and more of what we expect in 2027, we're also seeing governments and sovereigns issue a lot of debt as well at the same time. This is to fund their defense spending. This is to fund infrastructure. This is to fund all the requirements they have, alongside also entitlements and others such as healthcare. In our view, the markets are facing a lot of issuance through the course of 2027 and possibly even into 2028, but that's not it.

We also have a lot of news flow in geopolitics, which is having a real impact on markets. Energy costs are higher, inflation is stickier, and supply chain disruptions are clearly very visible. The result of all this is higher rates, both at the short end, but also at the long end, and also more volatility in markets that are dealing with these forces all at the same time. In this backdrop, investors and allocators are crucially looking for solutions which can provide resilience, which can provide true diversification, and which can also provide a differentiated risk profile.

This is why we believe securitized credit has a real important role to play to help investors, to help clients, to help allocators navigate these uncomfortable market conditions. At RBC, we have a number of securitized credit strategies that have been helping clients navigate these conditions now for a few years in a very constructive way. We focus across the capital structure from high quality, high carry investment grade strategies all the way down the capital structure to funds which focus on double-digit returns.

We have a global team. It's a team that's very specialised. It's a team that is focused on generating the best alpha that can be made, but with an investment process that's deeply focused on fundamental bottom-up credit underwriting, but it also blends with it factors that impact the macroeconomics around us. Alongside this, data, systems, infrastructure, risk systems, all are integrated and crucial to the investment process.

It's these core attributes which have resulted in RBC delivering the returns that it has over the last few years, which is top of the peer group in terms of risk metrics, but also in terms of overall return profiles. I will now hand over to Lucy and Tom, who will give you what I think will be a very insightful presentation on the benefits of the asset class and what role it can have as you think about portfolio construction and how best to navigate these markets.

Lucy: Thanks, Sid, and thanks again to everyone for joining us today. We are going to save some time at the end for questions, so please do scan the QR code on screen, which will take you to Slido where you can submit any questions that you may have. Just very quickly to recap the agenda for today, we're going to cover three main points. The first, just very briefly touching on what is securitized credit and give a bit of a summary for the asset class, and then we'll focus most of today's session on the second two points, spending time talking about the benefits of the asset class, and then finally, the different roles that an allocation to securitized credit can play in investor portfolios.

Let's take a step back and just really introduce the securitized credit asset class. At its core, securitized credit is about connecting the real economy to capital markets. What we mean by that is that securitized credit provides exposure to a number of different types of loans, different types of debt. Now, these different types of loans can vary from mortgages, auto loans, credit cards, all different types of debt that we are very familiar with, but what securitization does is it takes these different types of debt and transforms them into tradable bonds.

Now, these tradable bonds are then tranched by risk. You have a typical capital structure will run from AAA down to, say, B and equity. Each of the bonds in this capital structure have different risk and return profiles. They're paying different coupon rates, and they have a different exposure and sensitivity to the underlying collateral. Really, the asset class is providing investors with access to a very diversified pool of assets, diversified income streams, and very different investment opportunities. Then for originators of this debt, it's really about a diversification of funding source.

Now, the securitized credit market is roughly $5 trillion in size, and it is a true global market. Now, the asset class is then split into different areas, and there are four listed on the screen that we will focus on today. I'll just run through these very quickly. Firstly, we have CLOs, backed by corporate loans, ABS, backed by different types of consumer loans, auto leases, and credit cards, RMBS and CMBS, then backed by residential and commercial mortgages.

Now, securitized credit as an asset class has a lot of inherent benefits. This is what we're going to focus a decent portion of the time on today to just really understand the fundamental benefits of the asset class. We've split these on the screen into three key categories. The first are the credit benefits. Now, when we look at securitized credit as a whole, we would say that it's a very fundamentally strong asset class. What we mean by that is really a combination of having very strong underlying collateral and then a very robust structure in place. It's also an asset class that naturally de-levers, and these two characteristics combined make it very attractive for investors from that very strong credit perspective. Tom's going to spend some time going through those in more detail. The next two then really focus on why the asset class makes sense in investor portfolios. There are a couple of characteristics highlighted in the middle. Short spread duration. The asset class, as we've already seen, is quite diverse. You have different types of securities that you can access. What that means is that you can really play around in terms of your spread duration. There are some parts of the market, like CLOs, that are a bit longer spread duration, and some parts of the market, like ABS, that are much shorter.

Now, what that means is that especially if you have a diverse portfolio investing across the different parts of the market, you can actually naturally shorten your spread duration, which can be very beneficial if you're concerned about volatility, which the situation that Sid outlined in the introduction clearly makes sense to have that flexibility to shorten spread duration. You also have very attractive spreads in securitized credit, and we'll see that across all asset classes, spreads are wider than they are in corporate markets. Again, you have a very high level of carry in this asset class, which can provide a buffer in the event of market weakness.

Finally, the portfolio benefits, and really we'll spend some time on this at the end of the presentation today, but securitized credit does have a lower correlation to other asset classes. That's because it's not just corporate credit risk. There's lots of consumer risk within this asset class, and so that makes it a very attractive complement to more traditional fixed income and equities.

Finally, most of the asset class is floating rate. As you'll see when we come on to look at performance, in periods where there's lots of volatility in rates, securitized credit can really be a very strong complement for investor portfolios. I'm going to hand over to Tom to dig into some of these characteristics of the asset class in a bit more detail.

Tom: Thank you, Lucy. I think it's important to reflect on the fact that these benefits, they are inherent within the asset class. That means that an investor who invests in securitization gets these benefits at all time, but ultimately their relative importance does shift over the time depending on the different macroeconomic backdrops that we might find ourselves in. Clearly today, the fact that the asset class is largely floating rate has been a great benefit over the last four or five years, given the amounts of rate volatility that we've experienced, and that's an ongoing benefit. To start with, I want to dig a little bit more into the credit benefits. I think ultimately, when you're looking at any asset class, getting comfortable with the fact that you have a strong credit investment is the first step to making any investment.

For the next couple of slides now, I'm going to dig into these benefits in a little bit more detail. That's the fact that they have a high credit quality with strong protection against fundamentals, strong protection against idiosyncratic defaults. Then also, you get an added benefit that the asset class itself naturally de-levers across many profiles. That natural deleveraging, which then leads to more ratings upgrades and downgrades, is a great benefit across a bunch of different market environments.

To start with on this slide, and maybe just bear with me a second because it looks complicated, but actually it's a fairly simple slide to understand once you get into it. This slide, we're really going to demonstrate to you the credit quality of the asset class. Now, this is one particular example, but this can then be extrapolated across different asset types within our markets that we can talk about. This is an ABS example, but we can make the same analysis in CLOs and RMBS, etc.

The first thing to think about and understand when talking about securitization in general, when we talk about fundamentals, what we're talking about is a combination of the collateral with the appropriate capital structure. When we're doing our analysis, it's all about understanding the underlying collateral. We have a huge amount of transparency to do that in great systems where we can look line by line, whether that's mortgages, auto loans, or leveraged loans, etc.

Then you have to decide the quality of that collateral, and is it matched with an appropriate capital structure? Does the AAA bond have enough protection against defaults in your underlying collateral to warrant a AAA rating? Then so on as you go down the capital structure. This example I'm going to talk you through today is looking at the BBB level. That's the lowest rating that we would expect to see in an investment grade strategy. It's for a German consumer loan ABS.

Firstly, if you could just take your attention to the multicolored lines along the bottom of the chart here, what these are showing is historical default rates going all the way back to 2006 on a quarterly basis. Whilst you don't necessarily need to differentiate between these lines, what you need to know is that each one of them represents a different cohort of origination.

There'll be Q1 2006, there'll be Q2 2006, all the way up to the current day. What they show is the cumulative defaults. You look at that cohort in isolation, and then look how it defaults over time. What's important to notice from the chart, whilst we don't need to differentiate between the lines necessarily, what we need to ascertain is the fact that it's very consistent. We have a huge amount of data here going all the way back to 2006, where you can see cumulative defaults typically end up somewhere between 3% and 7% or 8%. Understanding how that collateral today is going to be represented in the future, we can use this history to help us do that modeling. Then what we need to do is we look at the capital structure that finances the purchases of these consumer loans. What we do is we say did the analysis and did the exercise. Where do these defaults have to go to? Where do these lines have to end up in order to impair or take one year of loss on the different tranches?

As I said here, we're looking at a BBB tranche. You can see you need somewhere in the region of 22%, 23% cumulative defaults in order to impair the BBB tranche. One of these lines would have to be three, four times what we've seen the worst in history. We're going through here the GFC, we're going through the sovereign debt crisis, we're going through COVID, we're going through the cost of living crisis. All of this is incorporated in this data. We'd have to see a cohort today that is multiple times worse than anything that we've seen historically in order to impair the BBB tranche.

There's a huge cushion of default for this particular transaction. It's doing this analysis. This is something that we do for every investment that we make. This result, as I said before, is broadly representative of what you see across the asset class. It is a very high quality asset class. Now, the second credit benefit that I mentioned earlier is the fact that the asset class naturally de-levers. What that leads to, as you see this deleveraging is you see more upgrades than downgrades.

In order to understand the deleveraging, maybe think about a mortgage bond would probably be the easiest way to understand it. If yourself as a consumer, have a mortgage, you're making a monthly installment on that mortgage, and part of that payment that you're making on a monthly basis to pay off your mortgage, part of that is principal, and part of that is interest. The principal component goes down to de-lever your house essentially, so you're paying off the balance of your mortgage. Hopefully, your house price stays the same. Your mortgage balance is going down, so your mortgage is becoming inherently less risky through time.

This deleveraging is then also mirrored in the RMBS structure because as you take the principal payments, you're paying off the AAA first typically. This helps to de-lever the actual RMBS structure itself. What happens then, as we go through time, we see these tranches, they tend to get more upgraded than they get downgraded. This isn't just the case in RMBS, it also happens in ABS and in other asset classes. Obviously, the dynamics and nuances are slightly different, but ultimately, you get the same pattern across different markets.

Now, what we've done here on this slide is a very simple exercise. What we do is on an annual basis, so you can see this goes back to 2014, but every year, we count the number of upgrades and we count the number of downgrades across the whole of the European Securitized Credit Market, and then we compare that ratio. If you have positive 100%, that would mean you get all upgrades and no downgrades in any one given year. If you have 0%, that would be the same number of upgrades and downgrades, and conversely, minus 100% would be all downgrades and no upgrades.

The dark blue lines on this slide show you the outcome for European Securitized Credit. The first thing to notice is that the bar is always above zero. Every year, even including the years of COVID in 2020 and the 2022-2023 cycle, even in those volatile times, we saw more upgrades than downgrades in our market, and that was purely driven by the fact that you have this natural deleveraging that occurs.

Now, if we compare that to European corporate markets, you get a much more typical, I guess, type of behavior in that you see when you have those big periods of shocks, and COVID has been a great example, you have a lot of downgrades. When there's uncertainty, it feeds through into the ratings. Their average does base much more around zero. Some years, corporates are deleveraging their balance sheet. They're doing well, they're getting upgraded. Other companies are doing poorly, they get downgraded. It matches out and averages around zero, whereas the average ratio for securitized credit is almost 70%. We have a lot more upgrades than downgrades.

Now, how can we incorporate this into portfolio management? There are a number of ways. Obviously, it's a key benefit, but one way we can potentially generate alpha, both in benign and in more volatile times, is to target investments, target bonds that we think are going to get upgraded more quickly than the market thinks. If you, say, buy a BBB bond a credit spread of 200 basis points, in nine, twelve months' time, that gets upgraded to A. Potentially, you'll see that trade from 200 basis points over cash to, I don't know, 175, 150. You've created spread compression, irrespective of what the beta of that environment is doing.

Now, if we look at the spreads that are on offer across the securitized credit market and compare those to corporate credit spreads, you can see that you get all of these benefits that we've been highlighting for higher spreads and higher yields. Now, what's very important is to understand that this credit spread premium is not being driven by fundamentals. It's not a fundamental risk premium. I think if you look historically, going back a long time now, pre-GFC, securitized credit, on a rating-by-rating basis, would have exhibited lower default rates than those that you experience in corporate credit.

I think what's also important is the forward-looking projections for defaults is also very low. If you think back to that slide where we were looking at the default cushion you have on the underlying collateral versus the capital structure, here we focused on the BBB tranche. That's because that's the "highest risk" tranche that you would see within a IG portfolio.

There was a big cushion. Clearly, if you go up the capital structure to the A, to the AA, to the AAA, you have more and more cushion and more and more protection against defaults. That's what makes us comfortable to make the assertation that we think it's a very high quality asset class historically and on a look-forward basis. The question then becomes, what is driving this differential?

In our opinion, it's really a market structure and more of a technical reason for this differential to exist. Now, what do I mean by that? There are a number of nuances that have meant that the buyer base has been relatively constrained historically. One example would be the fact that securitization doesn't typically make it into benchmarks. For benchmark-constrained investors, they would not typically have demand for securitization.

The other big investor that has been absent from securitized credit markets has been insurance companies. That's because the Solvency II capital charges, which govern the investments of insurance companies in Europe, they have been punitive historically, post-GFC, for insurance companies to invest in securitized credit. You can see their investments across their balance sheets is very, very low. Typically less than 1% of assets.

Interestingly, if you compare that to what's happening in the US, the average there is more like 20%. In the US, they have that big buyer. In Europe and the UK, we do not. Now, what's quite interesting is that they're actually making changes to this regulation come into effect in January, so it's a very topical discussion at the moment, which we'll see those capital charges reduced. In some cases, very dramatically, particularly the one that the big beneficiary is going to be AAA CLOs, is the expectation.

That should see demand start to increase from the insurance buyer base and potentially see spreads compress from that angle. Ultimately, we're also seeing very high supply in the market, so it's always a bit of a balancing act from those two forces. Ultimately, just to reiterate, we do not see this as a fundamental credit spread premium, but more of a market technical structure premium. It's very attractive to be able to access that as a securitization investor.

Lucy: As we've seen, the asset class has a lot of inherent benefits that make it attractive for investors as a strategic allocation within their portfolios and particularly relevant in today's market environment. When we think about the asset class, there are a number of different ways that it can be used for investor portfolios. Just at a high level, we've put some of these on the screen.

Firstly, at the most liquid, high quality end of the spectrum, strategies that invest in the AAA part of the market in very shortspread duration provide a really good solution for cash enhancement. Here we have strategies that are daily liquidity vehicles that are designed for investors, not for cash that they need in a few weeks' time, but for medium-to-long-term cash allocations.

I think one of the core areas that we've seen a lot of interest from investors and a lot of growth in our platform has been within that middle section as the IG complement. Now, investors broadly have a lot of exposure to investment grade, be it corporate credit or government risk. I think securitized credit in the IG part of the market can provide a really good complement to some of that more traditional investment grade exposure. We're actually going to demonstrate that over the next couple of slides.

Finally, as you've seen and heard across the platform discussion and across the asset class discussion, this is an asset class that has tranches of risk with different risk and return profiles. As you move lower down that capital structure, here the yields on offer are very compelling. For investors looking for some more diversification, high target returns, high yields, it can provide a really good complement to more traditional asset classes such as loans and high yield debt.

Now, as we demonstrate I guess the benefits of the asset class, but also overlay our investment approach within this market, here we're going to dig a little bit more into a couple of the strategies that we manage and how they have performed over recent market environments. Just very quickly, we're starting here with our broader investment grade asset-backed credit strategy, which is represented in the dark blue line. This is a daily liquidity vehicle that invests in IG-rated securitized credit assets, so from BBB and above.

On average, you'll see that it is generally a very diversified strategy across both rating bands and also across asset classes. The high grade strategy is, as I mentioned, really designed to be a cash enhancement, with a slightly lower target return and focusing mainly on the AAA part of the market. What we're showing here just very simply is the performance for these two strategies over both the year-to-date period and then slightly longer term on the five-year.

Year-to-date is one that we often look at because I think it's very fresh in everyone's mind, the exact market environment that we've been in over the course of this year. You can see that both the IG and the high grade strategy have shown very resilient performance. This is then amplified when we look over the five-year period. We've gone from an environment back in October 2021, we were actually at a tighter spread environment than we're in today, through to October this year.

Now, clearly, over that five-year period, there's been a lot for markets to contend with and several periods of volatility. Once again, you can see that both strategies have delivered very robust performance. Now, what's very interesting for us, and I guess for securitized credit in particular, it's quite difficult to compare performance when you don't have many benchmarks.

There's a few things that we do. We look at our performance versus our targets. We look at performance versus other credit markets. Then finally, we look at performance versus peers. Here, when we overlay some other credit markets, you can see it's really demonstrated the benefits of the asset class and also with our investment approach. Lots of lines have now been added on the screen.

First, you can see in the orange line, we've added European loans as another floating rate asset class. We've added European high yield in a browny-grey colour, European investment grade, a shorter duration index in green. Then finally, just the pure cash benchmark in a light blue. Just looking at the year-to-date period, you can see here that there's been a lot of volatility really in credit markets.

You can see a drawdown in loans actually came first at the beginning of this year, driven by the volatility in software. Then clearly, the sell-off, as the escalation with the Middle East occurred late in February. Then as you move, I guess, through the summer months, you had a bit more resilience in markets still with a very uncertain macro backdrop. Then more weakness has come in credit markets. Firstly, driven by the big move higher in rates. Then secondly, by some credit concerns building, particularly in the high yield market.

You can see when you compare the performance of the strategies, actually they have been very, very resilient. That stems down to two factors. It's the benefits of the asset class. The floating rate element, more consumer risk, diversification away from a pure corporate risk. Also, the fact that throughout this period, we've been actively rotating the portfolios to mitigate drawdowns, but then also capture on the upside as well.

I won't go through the five-year in as much detail, but really you can see this same dynamic once again. Clearly, a lot of weakness in markets in 2022 with Russia, Ukraine, and inflation. Whilst there was a drawdown within the securitized credit funds. This is much lower versus the other credit indices. You can see that actually both strategies have delivered very strong performance.

Just to reiterate, that yellow line is the high grade strategy, which is a AAA-focused vehicle. The blue line is the diversified IG strategy, which on average is typically around a AA minus credit rating. Very, very high quality assets delivering extremely robust performance in both the short and long term. Now, as we move forward, I've mentioned that the investment grade complement is one of the key areas that we've seen a lot of growth within our platform and a lot of interest from investors.

Here, what we're showing very simply is just looking over the past five years of data. What happens when you have a pure investment grade short-dated index, and you add increments of 10% allocations to the investment grade asset-backed credit strategy that we manage? You can see what happens is you're improving your overall return when looking at historical data and also reducing the volatility.

Now, that's evidence on the charts that we just went through. You can see it makes a very significant impact as you add more and more exposure to investment grade ABS. We do truly believe that it's a fantastic complement for investors alongside their existing investment grade corporate and sovereign allocations. As we mentioned, there are a few ways that we look at performance. One of them is by looking across peers.

Now, in securitized credit, I'd say within the investment grade space, there are a lot of other managers who are aiming to achieve a similar objective as us, investing in the IG part of the market, diversified exposure to secured credit in a daily liquid format. Our product team look across the Morningstar universe and select other peers to compare performance who are all aiming to do a similar thing.

What we have delivered over both the long-term and the shorter-term is a really strong performance track record versus our peers, and this is taking that investment grade strategy again. You can see on a year-to-date basis, we have delivered top of the peer group performance, really mitigating some of those drawdowns earlier this year around the software, volatility, and also around the conflict within the Middle East.

You can see that that same basis has been delivered over the five-year as well, so really delivering very strong peer performance. Now, it's often quite difficult to ascertain exactly what has driven the very strong track record that we have. Really, I think it's a combination of a lot of factors. We have a real focus on the credit underwriting, so really digging into the underlying collateral, the structure, the originator is something that is very key to our investment process.

Even when we're investing in those very senior tranches, which, as you could see in the slide that Tom took us through with the credit protection, you are very well insulated from a deterioration in the collateral, but we still feel very strongly that we can deliver strong performance from really doing that deep credit underwriting process. As well, I'd say a lot of the key drivers come down to our overall investment process and approach. There's not enough time today to really go through that in a lot of detail, but really we focus on delivering very attractive relative value. We are continuously looking for the best opportunities across the market.

Our portfolio turnover typically is higher than peers, but we think there's a lot of value in doing so, and that's really shown in that peer group performance. The final thing I'd say is that we have a really robust portfolio construction framework, which we have designed five years ago now and have been running the portfolios in the same way for a long time. I think that combination of the focus on credit underwriting, the focus on relative value, a very diligent and robust portfolio construction framework is really what drives this strong peer performance.

The final point to make is probably that we are embedded within the wider RBC business, so we can get a lot of information, lots of macro colour, lots of discussions with the other specialists across credit markets here at RBC. I think that's a real benefit because securitized credit is an asset class that can often lag other parts of the fixed income market. As we hear and discuss with our colleagues about dynamics going on in high yield or loans, it can really drive some of those investment decisions that Tom and the rest of the portfolio managers will be making.

Before we move to questions, I guess just very quickly to summarise the discussion that we've had today, really this is an asset class that can provide a lot of value for investors. We do really think securitized credit should be a strategic allocation, not just a tactical one in investor portfolios, because the asset class continuously delivers very attractive performance versus other credit markets. It's driven by a combination of those benefits listed on the page, the floating rate exposure, very high credit quality, very robust structures, attractive spreads, and shorter spread duration.

All of those combined, we think make it a worthwhile addition in investor portfolios, but really, what drives that very strong performance is our approach, which we have delivered that strong peer group performance as a result of our very active and relative value-focused investment process. Let's take a look at the Slido to see some of the questions that we've had in. Tom, I think in the session today we spent a lot of time talking about the general benefits of the asset class, but how would you summarise the current opportunities in the securitized credit market today?

Tom: Good question. Thanks. I think there are a number of benefits, obviously, of investing in the different parts of the market, but there are also portfolio benefits from having diversified exposure to securitized credit because what we do when we're doing this active management that you're talking about is we allocate capital between the different parts of the market and up and down the capital structure.

We're constantly thinking about the relative value, not just of securitized versus broader credit markets, but also within securitization. That shapes how we construct portfolios at any particular point in time. Obviously, it's a very interesting period. At the moment, we've seen a lot of volatility come through credit markets broadly since the September and post-summer period. That has driven us to different parts of the market. This time around, it's actually not the usual way that things happen. Normally, CLOs being a longer spread duration part of our market, they typically have more volatility.

What we've seen this time, actually, the opportunities are presenting themselves more in ABS and RMBS, and particularly within new issue markets. We've seen some spread widening, and the fact that we have a few of the bigger buyers seemingly on the sidelines. At the same time that we've seen a huge pickup in supply, which always happens in that September, October period. The fact that we've had volatility, less demand, and higher supply, particularly for ABS bonds, has led to opportunities in the new issue space.

Just to give you the short answer there, somewhere like AA ABS, I would point out, has been extremely attractive today. If you go back to the summer, that would be priced in a 90 to 100 basis points over cash, whereas today, we've participated over the last couple of months or so in some transactions where we've been getting north of 150 basis points. That's a big spread move for what is an extremely high quality investment. To answer the question, today, we see the best value in ABS and RMBS. We're on the sidelines, a little bit of CLOs, waiting to see how that opportunity develops.

Lucy: Great. I guess this one relates to the response you just gave, given that a decent amount of the volatility that we've seen this year has been related to AI. How do you see the impact of AI in the asset class more broadly? Clearly, you've already mentioned CLOs as an area, but how do you think about risks for securitized credit?

Tom: I think, as Sid alluded to in the introduction, AI is changing the world. I don't think there's any part of our day-to-day lives or financial markets that are going to be completely isolated from it. What I would say is, within our markets, because you have this tranching effect, you're able to target very high quality investments where you are more removed from underlying idiosyncratic risks within portfolios.

On top of that, a large portion of the investments that we make are in more iterated, say, consumer-related asset classes, so within ABS and RBS. Those are much more isolated from direct impacts of AI. Within our asset classes, where you see those direct impacts becoming more relevant are within the CLO space because you have corporate loan underlying there. It can be very hard to, I think, identify the winners and losers from AI at any one point in time.

The benefit we have as securitization investors, particularly as you go into the IG and higher parts of the market, is you get hedged against those idiosyncratic risks. You don't need to necessarily know exactly which corporate is going to win and which corporate is going to lose, as long as you have enough protection to withstand a large wave of defaults, which we think you do at definitely the BBB and higher level within CLO markets, you do find yourself more protected against the risks that are prevalent today in the markets. For sure, AI is not going to go away, and it's going to be an important target for financial markets going forward.

Lucy: Yes, definitely. Again, this is a question that you've given a bit of the answer to, but I do think it's a very important one, particularly when there's been a real surge in investments in something like CLO ETFs. How do you see the benefits, I guess, of investing in portfolios that are more broadly allocated into securitized credit versus something that is narrowly focusing on one asset class?

Tom: I touched upon that in the first question, but ultimately, I think there are huge benefits to having a diversified portfolio from a portfolio manager's perspective because these parts of the market are not completely correlated with each other, which allows us to, when there is volatility, we can sell down the parts of the market that are performing well and maybe buy parts of the market that are offering more value at any point in time. Having that diversification is very important.

As I said, typically, the playbook tends to be ABS and RMBS being shorter spread duration has less spread volatility, typically. For example, Liberation Day is a great example of that, where we were selling assets very much up to Liberation Day, even post-Liberation Day, from the ABS and RMBS portion of the portfolio and reinvesting those into CLOs, which had sold off more from a spread and price perspective. That's the typical playbook.

As I said, today, the environment is slightly different, and we're doing, I guess, the reverse in some respects, investing in ABS and RMBS as new issue markets. Ultimately, having that diversification leads to these strong portfolio returns that you're seeing now that we've demonstrated over many timeframes.

Lucy: I think there's two more questions that I'd like to ask. These are both really good questions because I think we get them quite a lot in our investor meetings. You've talked a lot about how we can actively rotate the portfolios. How would you explain how liquid is the market? Maybe how does IG securitized credit compared to something like IG corporates?

Tom: I guess we've spoken a lot about other benefits and the returns available in the market. If you think about liquidity being another, obviously, key component of managing portfolios, that has, again, time and time been demonstrated over the last five years and plus. I guess the benefits of having these pairs of volatility, and going back prior to that, I guess, is that we're able to demonstrate not only the performance of the asset class, but the liquidity that it has to offer.

I think the main example of that that we have had in the last five years or so has been the LDI crisis back in September 2022 when you had the mini budget in the UK led to a big sell-off in gilts, and there was a big portfolio rotation out of securitized credit. We saw in that two or three-week period, a huge amount of supply hit the market, and it was very orderly. It got very well absorbed. We can obviously send data to anybody that's interested because we have a lot of data that covers that period, but not only that period, but I guess over a longer period of time as well.

Specifically that time, there was a huge supply shock. It was very well absorbed, and it's a great case study for the liquidity on offer in the market. To answer the question succinctly, the liquidity within our space has been very good, and that has been demonstrated over the last five years.

Lucy: Great. I guess the final question to finish on, I think hopefully we've done a good job today of explaining some of the characteristics of the asset class. Look, this question says, "The asset class is quite complex. How would you justify an allocation in portfolios versus something like traditional investment grade, which is more well understood?"

Tom: I think as you've said, we have hopefully, over the course of this webinar, demonstrated the benefits of having an allocation as a complement to a traditional IG portfolio of the securitized credit asset class. This question of complexity comes up from time to time. I actually feel quite strongly that this asset class is not complex, particularly, I think, when investors are making the comparison with complexity and risk. If you're saying complexity equals risk, I think this is definitely not the case in our market.

I think if I can maybe try to explain why I feel this way about using the word complexity. If we take an RMBS example, a residential mortgage-backed security is backed by residential mortgages. This is a type of financial instrument that a lot of people have, so they're very familiar with it. An RMBS, what it does is it buys a portfolio of mortgages. There might be 2,000, 3,000, 4,000 mortgages in a portfolio, all exactly the same as the mortgages that you or I might have on our own properties. It then has an entity, the SPV of the RMBS, issues debt. It issues the RMBS bonds in order to finance the purchase of these mortgages.

I think what's really important is this entity doesn't have free will to behave as it wants. Its only exposure is these mortgages. Its only exposure is ever going to be these mortgages. There's not a management team that sits within this entity making decisions on a day-to-day basis. You're not going to wake up one morning and the management team's decided to issue some more debt to do a leveraged buyout of a different business to change the risk profile of what that entity is trying to achieve.

There are very strict rules as to how that entity has to behave, which are all written down in the prospectus. Now obviously there is an analysis required to go into this. We have to analyze the collateral. We have to analyze the waterfall and how different transactions might behave. What I would say is that the structures themselves have become fairly standardized over time. They're all very high quality. It's something that we do, and we understand it very, very well. From our perspective, I would argue that they're not complex from that perspective. That clearly, a lot of credit work goes into making sure that we're making sound investments, and the analysis that we showed you earlier is valid.

Lucy: I think maybe one thing that's perhaps more misunderstood is just the level of transparency that we do have when investing in these assets, so that line-by-line information on collateral, as you say, the detailed prospectus, all of that really helps you do the analysis before making any investment.

Tom: Yes, exactly. Every single investment we make, we have a line-by-line of the individual collateral, whether that's mortgages, auto loans, corporate loans. We have exact information in the prospectus that says for every dollar, for every euro, for every pound that's coming from that, whether it's a prepayment, a default, and so on and so forth, how it then flows through the structure and gets paid to the AAA down to the BBB.

I think in summary, I would argue definitely that this is not a complex asset class, particularly when you're making that linkage to complex, meaning high risk. All of these benefits that we've been talking about are very well understood and beneficial to portfolios for investors to invest in. Yes, for sure. OK great, thanks Tom.

Lucy: Thank you to everyone for joining, thank you for your excellent questions. There were a few that we didn’t get to today so if there is anything outstanding then please do follow up with your RBC sales rep. Thank you.