Dollars and Sense podcast

Mike Reed 00:04
Hello, and welcome back to the RBC BlueBay podcast Dollars and Sense. I am Mike Reed, Head of Global Financial Institutions. Today, I'm pleased to be joined by Sid Chhabra, who is head of Securitised Credit and CLO Management & European High Yield. Sid has over 19 years of credit, securitised credit, and CLO experience, having been involved in securitised credit markets from the earliest stages of issuance. He has seen the asset class grow from a specialist niche to become the global market it is today.

Securitised credit has outperformed most traditional fixed income markets over the last year, but many investors remain circumspect, and it's underrepresented in their portfolios. With such depth and breadth of experience, I believe Sid is well-placed to help us navigate this interesting segment of the investment universe. Sid, welcome. Good to have you back on the show.

Sid Chhabra 00:56
Well, thank you, Mike. It's great to be back.

Mike Reed 00:58
Really good to have you. Sid, can you give us an overview of the asset class and how it has evolved over time? What are the different sub-asset classes, and how would you differentiate them in terms of exposure?

Sid Chhabra 01:12
Yes, sure, Mike. Securitised credit market has, as you mentioned, grown to be one of the largest fixed income markets globally. If you actually think about the market size today, and I'm going to include and exclude agency mortgages and give you the numbers…so if you include agency mortgages, it's over USD13 trillion in outstanding stock, and if you exclude US agency mortgages, it's still a very large asset class in over USD5 trillion. It's a very large, liquid, public markets-oriented asset class. To give you a sense of where Europe ranks within this global USD5 trillion, it's about a third, a quarter or third of that.

So, if you think about the evolution of the asset class, as you mentioned right at the start, it has continued to evolve now for multiple decades. I think the initial transaction started way back in the 1980s with the evolution and a bit of sophistication and innovation within the mortgage market in the US. Then it continued to focus on other asset classes, such as credit cards and auto loans and corporate loans, through the 1990s and 2000s. Today, it is a very meaningful size. As I mentioned, it's close to USD5 trillion.

I think what's most interesting about it is not just the fact that it's size, not the fact that it's liquid, it's public markets-oriented, but it's actually not a single asset class. It comprises a number of sub-asset classes. To give you a few examples, people use the term asset-backed securities, or ABS. It typically refers to those transactions or the asset class that's backed by consumer receivables. Think about auto loans or credit card loans, personal loans as an example.

Then you have another sub-asset class, typically where transactions are backed by residential mortgages. These are residential mortgages across a various range of jurisdictions, whether it's the US market, the UK market, or many of the European markets. Now, these are consumer-oriented because, essentially, you're exposed to consumers paying back their receivables, whether it's on the loan side or the residential side.

Alongside this, you also have corporate markets in the sense of corporate senior secured loans, which are the underlying pool for securitised credit transactions. This market, also called the CLO market, is actually quite large. It's over USD1 trillion, in fact, approaching USD1.5 trillion. It's one of the faster-growing markets or sub-asset classes within securitised credit. So, you have the consumer side, you have the residential mortgage side, you have the corporate side, but also you have other areas which are also attracting a lot of interest within commercial real estate. You have industrials, you have logistics, you have data centres, which are very active right now.

As you can see, securitised credit is not just one asset class. It's actually a number of sub-asset classes across various jurisdictions, which means that there's a lot of diversification. There's a lot of variety for the asset class. There's a lot of issuance taking place. When you have a USD5 trillion asset class, there is half a trillion to a trillion of issuance every year across these markets. It's a very rich, diversified asset class that keeps us very busy, I would say, on a day-to-day basis.

Mike Reed 04:31
That's a great intro. I'm amazed by the diversification there and the different areas you can get into. It's such a major asset class. I don't think people realise that USD5 trillion, that's multiple times the size of, say, the US high yield market, which we've talked about. I mentioned at the start that the outperformance of securitised credit relative to other fixed income asset classes over the last 12 months…what have been the principal drivers of this, and could you describe the benefits relative to other fixed income asset classes at this time?

Sid Chhabra 05:06
Yes. The key fundamental driver of performance, to be honest, for any asset class firstly boils down to the fundamental performance of the underlying exposure. What I mean by that as it relates to securitised credit markets is that you have to have the consumer doing well, and you have to have the underlying exposures doing well. That's what we have seen over the last 12 months, 18 months. We're also going back over the last 5 to 10 years, which is a resilient, fundamental performance, which has meant that delinquencies and defaults have remained on the lower end. It's largely on the back of the fact that, in general, if you look at developed markets, both US, UK, and Europe, although the growth backdrop has been a little varied, the employment backdrop has generally been quite stable. Primarily, good performance comes from good fundamentals. That's what we've seen within securitised credit markets, because ultimately, the consumer backdrop and the corporate backdrop, despite many challenges, have been somewhat resilient.

Above and beyond that, there are features and structural nuances of securitised credit which has added to providing that backdrop of better performance and outperformance versus corporate credit and fixed income markets. What are these features? A large part of the securitised credit market is floating rate. That means you have very little rate duration exposure. A large part of the market typically also comes with lower or shorter spread duration, which means that the mark-to-market sensitivity of the asset relative to spread moves are also a lot lower when you compare it to long duration IG or, as an example, long duration sovereign credit.

The structural features has also meant that over the last 12, 18, 24 months, when there's been a lot of rates volatility and, in many cases, periods of dislocation where spreads are widened, securitised credit has proven to be quite resilient and continue to perform and outperform relative to corporate credit markets and sovereign credit markets.

Finally, what I mentioned earlier, it's a large asset class. It's a varied asset class. There's a lot of issuance in markets. There's a good demand side of the equation as well, but the supply side has remained strong. Gross issuance is strong. Net issuance is strong. The asset class is growing.

When there is this pick-up in supply, and you see a lot of different types of transactions, you typically get a spread premium relative to secondary markets, but also then the spread pick-up relative to corporate credit markets also is very strong. Putting that all together, essentially, what you have benefited from is lower exposure to rates, lower exposure to spread sensitivity because you have lower spread duration, a good fundamental performance, lower delinquencies, lower defaults, and a spread premium relative to corporate credit, which means that last 12 months, 18, 24 months, you have gotten this high-quality income, high-quality carry, high-quality returns that have continued to compound and has led to this performance or outperformance versus corporate credit markets and fixed income markets in general.

Mike Reed 08:25
It's been very notable to the returns, and it's very clear that's the case. That's slightly looking back, but looking forward now, so given your current market outlook, could you maybe frame securitised credit within the risks and opportunities of overall markets? Right now, and one thing you did touch on was the high levels of rates volatility that we've had over the last year. Do you see that continuing? Is that something that would continue to benefit, or is this the time to move back into more standard fixed income duration?

Sid Chhabra 09:02
Yes. I would say that my personal view on the macro challenges is one that we are seeing a lot of geopolitical instability. We're also seeing, as a result of that, energy prices remain elevated. We're seeing the inflationary backdrop to be under pressure, and that those pressures have eased and ebbed a little bit compared to where we were several years back, but they remain above central bank targets. That is a backdrop where, in my view, rates will remain higher for longer. Also, it comes alongside a backdrop where governments have very high budget deficits, alongside which there's a lot of issuance taking place as a result of the AI capex boom.

I don't think this is a backdrop where we can expect lower rates volatility. Frankly, I expect to have higher rates volatility. If I just think about that backdrop where you have higher rates volatility, a lot of issuance coming from various parts of the fixed income markets, but also higher rates, which means that if you are a more levered exposure, let's say you're a lower single B-rated corporate in the high yield space or the loan space or in the private credit space, you are likely to face more pressures and have been facing those pressures, which means that the risk of idiosyncratic events is higher.

The other aspect to help mention over here to frame this discussion is that we're also seeing more AI disruption in markets. As a result of this AI disruption, it's very likely that certain sectors will benefit, but also there'll be certain sectors that face challenges and margin erosion or loss of revenue as a result. Therefore, you're going to likely see idiosyncratic risk remain elevated.

In this backdrop of more rates volatility, higher idiosyncratic risk, a lot of issuance, we want to be in markets which are more oriented to shorter duration, which have lower spread duration, where the fundamentals are different and resilient, and also where you're getting that spread premium and issuance volume which allow you to be selective. This is where I like securitised credit markets because if you think about those challenges, and therefore the features that you want to help diversify the risks, then securitised credit markets actually fit quite well because they are, on large parts, lower spread duration assets that are available. The focus on rates duration is a lot lower. Spread premium is higher compared to corporate credit, and there's a lot of issuance. And the fundamental backdrop is quite resilient.

To me, securitised credit in this challenging backdrop will continue to provide quite a good backdrop for returns, high-quality returns, high-quality income compared to corporate credit markets. That's been the recommendation that I've been making, talking to investors and allocators, as to what is the right place of securitised credit as an allocation within portfolios to diversify the risk away from these inherent risks of higher inflation, higher rates volatility, and idiosyncratic risk that seems to rest in existing portfolios for many of our investors and allocators.

Mike Reed 12:28
That's a really interesting and strong argument there, I think, for securitised credit. We touched on it briefly again at the beginning, but I'd say when I talk to investors, two of the main attributes that they seek when constructing their portfolios are diversification and liquidity. Obviously, there's been a lot of talk about private markets recently and the lack of liquidity there. Do you feel securitised credit can provide these benefits to a portfolio?

Sid Chhabra 13:02
Yes, absolutely, 100%. If you think about, as I mentioned earlier, the structure of portfolios that allocators are most exposed to, it tends to be very heavy towards corporate credit, particularly long duration corporate credit. I'm talking about within fixed income markets. Obviously, they're going to have exposure to equities, and within equities, things like private equity. If I think about fixed income markets, a substantial portion of that exposure will be either to long duration corporate credit and to sovereign credit.

Now, one can, I think, observe quite easily that sovereign credit or sovereign exposure balance sheets of governments is deteriorating because of the amount of issuance that's taking place, and perhaps growth is not keeping up. You see debt-to-GDP ratios going higher on almost a yearly basis. We see that in Europe. Obviously, we're seeing that in the US as well. Given that allocation that most investors have, every conversation of mine tends to be about how do we diversify away from this existing type of risks we have and into areas of the market that can provide that diversification, but a different type of risk exposure.

I think this is where securitised credit has had a meaningful benefit to these allocations coming from investors, because as we've discussed so far, you're getting exposure to, in many cases, consumer receivables, to residential mortgages. Where you're taking corporate credit exposure, it tends to be in the form of IG parts of the capital structure or mezzanine parts of the capital structure where you don't have exposure to the idiosyncratic risks that can exist within sectors or single names.

With the diversification benefit, I think it's quite clear just by the discussion we have had about the different sub-asset classes. There's also a diversification benefit that's coming because the structure of securitised credit means that the underlying features, such as lower rates volatility exposure or lower spread duration, means that also that exposure that you're getting in terms of the structure of cash flows is different from your long duration exposure. I think there's a very clear evidence of diversification, lower correlation benefits that you're getting from allocating more to securitised credit.

Now, the added benefit, I would say, and a very clear benefit also, is liquidity. It's a USD5 trillion-plus asset class. If you add agency mortgages, it's over USD13 trillion. It's a massive asset class. There's hundreds and hundreds of billions of issuance that takes place every year in the CLO market alone. If you add up the CLO market, the ABS market, the residential mortgage market, it's well over half a trillion, and approaching a trillion of issuance every year. There's a lot of trading that takes place, buy and sell that takes place every day within the US broker-dealer and the European broker-dealer space. There is just a lot of activity taking place in markets, and bid-offer spreads tend to be quite low.

So, I'm not at all worried about the liquidity of the market. Frankly, when you allocate to securitised credit, typically, you're allocating not just away from long duration assets, but many times away from parts of the leveraged finance market, both in public markets, but also in private markets. Not only are you maintaining liquidity, in many cases, you'll be improving liquidity. To recap this, you're adding clear diversification, but you're really not compromising liquidity. In many cases, you're enhancing liquidity by this additional exposure to securitised credit markets.

Mike Reed 16:42
It does sound like it's what a lot of investors are seeking and what they talk about whenever I talk to them. Those that aren't involved in it should definitely have a closer look at this. Now, I have to ask you this one because obviously we've talked a lot about the merits of securitised credit, but it's obviously important to consider how any asset class performs during, say, periods of stress. We can look back over the last decade. We have witnessed significant periods of volatility. We've had energy shocks, inflation, Covid, tariffs, war. I mean, it's just a few! How has securitised credit performed during these periods?

Sid Chhabra
You're absolutely right. I think it's been a great test case for credit markets and securitised credit markets that, in fact, the market has faced all these challenges. In some ways, if I dial back a few years and if you had told me all the challenges that the markets would face, as you mentioned, Covid, inflation, energy shocks, war, not just one war, two wars, as an example, much higher rates, budget deficits, deteriorating balance sheets, you would have argued for a much worse performance in general for fixed income markets, and parts of the markets have underperformed.

Coming back to securitised credit markets, I'm actually quite glad that the market has faced these many challenges because if you actually look at performance over that 5-year period, over that 10-year period, I would say it's been resilient, and it's actually been quite robust, frankly. The main attributes that have contributed to that is that the underlying performance, the fundamental performance of the sub-asset classes, has continued to remain firm.

If you think about consumers, consumers do well when they're stable in employment. Actually, if we look back over the 5-10 years, obviously, we had this blip during Covid, but other than that, generally, consumer balance sheets have been in good shape. They don't have that much leverage. Generally, employment has been stable. They've been able to perform well on the obligations that rest on them. Consumers have done well.

Corporate credit markets have had pockets of weakness. It's clearly evidence that you've seen higher defaults amongst the lower-rated corporates, whether it's the loan space or the high yield space. Despite this, CLOs have done well because for most of the CLO asset class, which is the mezzanine asset class and the IG asset class, you have significant cushion to these idiosyncratic events. The backdrop has been one where there are a lot of challenges, there's been a lot of shocks, but as long as the fundamentals have been firm and robust, you continue to see their performance, and that's what you've seen.

And so, in my view, I think, in some ways, glad that the asset classes faced these challenges. That's what our belief is, as long as we believe that consumers are likely to remain resilient, and as long as, on the whole, corporates are likely to remain resilient where default rates are moderate and not too high, I think securitised credit markets, like they've performed in the last 5-10 years, are likely to perform well on a go-forward basis as well.

Mike Reed 19:59
That's good. I'm now coming to the crystal ball questions. Looking to the future, as we look through this crystal ball, how do you see demand for securitised credit evolving? There are obviously some changes to the Solvency II regulations in 2027, which are going to lower capital charges for senior tranches, which I've heard people say this will create a structural shift in demand from insurance in particular. Do you think this is likely? I know insurance historically used to own more of this asset class. Will they go back there again?

Sid Chhabra 20:33
Even before coming to that change in insurance regulation, to be honest, a backdrop for a broadening of investor base has been with us now for several years. All the features and the attributes we spoke about with respect to securitised credit has continued to draw a wider and wider investor base. It's not just your traditional asset managers or banks. We're seeing more family offices, more types of investors across Asia, across Middle East allocate to securitised credit. We've had this natural broadening take place. In fact, even within traditional asset managers or traditional investors, the allocation of securitised credit on a strategic basis is increasing.

I don't want to repeat everything we've discussed, but it's all the key attributes that make securitised credit such a key and interesting allocation for investors to diversify that risk away. Now, on top of which, there has been actually, I would say, regulation, particularly in Europe, that has been, I would say, a hindrance, but certainly been one that has kept a very large buyer base from allocating securitised credit because the capital routes were, in my view, quite punitive. Those are changing now. Our expectation is those changes will come through in 2027, which will mean that more insurance companies will be able to allocate.

Now, what are these changes? In a nutshell, essentially, what's happening is that the capital charges for owning securitised credit, even the most senior tranches, which have performed extremely well, are very high compared to corporate credit. Because of these very high charges, insurance industry on the whole in Europe, which is a very large industry, including the UK, weren't really allocating to securitised credit, whether it's AAA CLOs or AAA ABS. That's starting to change from 2027 because the capital charges are coming in lower, and they're going to be more competitive relative to corporate credit markets.

We do think that that tailwind will continue to form in 2027 and extend over several years. It's not just for the European insurance sector, but also in UK, we are seeing a more favourable backdrop. I do think that this will be a meaningful tailwind going forward. It is important to highlight that it's an important tailwind. It's not the only tailwind. The real tailwind, I think, is coming from the fact that the investor base in general is broadening because the asset class is doing well.

When you combine that broadening that we're seeing with many other jurisdictions like Asia, Japan, coming in where more investors are looking for this type of exposure, and then you have some favourable backdrop on the regulatory side, I do think that tailwinds are quite meaningful going forward. There'll also be good demand and good supply. I do think the market will remain quite healthy, which is you're going to see more supply. You're going to see this backdrop of better demand because more investors are allocating to the asset class. I think it'll be a good, healthy, balanced mix of supply and demand, which means that spread premium should continue to exist. I'm quite excited about what we are likely to see over the next few years.

Mike Reed 23:42
Yes, I'd agree with you. Looking at our client flows, our client interest, your strong track record within you and your team, and how you've built the business over the last decade or so, it's been incredible. Even putting aside the Solvency II regulations change, we're definitely seeing a big and broadening pick-up in demand across our existing client base. 

Sid, thank you for joining me today. It has been a pleasure to have you on the show, sharing your thoughts and insights on an asset class that is clearly going to become an important part of investors' allocations over the coming years.

Sid Chhabra 24:19
Thank you, Mike. Thanks for having me. It was great to be back.

Mike Reed 24:22
If you wish to learn more about securitised credit, we have several white papers available on our website, www.rbcbluebay.com. I think you will find these useful and interesting. Many thanks for listening to the show. If you've enjoyed it, please like and subscribe on your podcast platform of choice. 

We will be back next month when I will welcome back Laurence Bensafi from our Emerging Markets Equities team. EM equities have outperformed US and European markets so far this year, and I'm interested to find out what's been behind these moves and if Laurence thinks this is a trend that can continue. If you wish to listen to any of the previous editions of the podcast, they can also be found on our website, www.rbc.com, or on Apple, Spotify, or Google. Thank you once again for joining us today. Good luck and goodbye.