RETURN ENHANCEMENT WITH EUROPEAN ABS AND BANK LOANS IN SWISS INSTITUTIONAL PORTFOLIOS

H E A L T H W E A L T H C A R E E R RETURN ENHANCEMENT WITH EUROPEAN ABS AND BANK LOANS IN SWISS INSTITUTIONAL PORTFOLIOS JUNE 2017

INTRODUCTION In the aftermath of the global financial crisis, conventional and unconventional monetary policy has driven yields to record lows in public bond markets globally. In addition, the Swiss National Bank introduced negative interest rates to fight the appreciation of the Swiss Franc, sending domestic government bond yields into negative territory and increasing the cost for hedging currency risk inherent to foreign bond investments. Swiss institutional investors profited from valuation gains while yields were falling, but risks are now twofold: Should the current situation persist, fixed income returns can no longer provide a decent contribution to reach target returns, and should yields rise, valuation losses will incur on fixed interest investments. One option in this environment is to invest in lower credit segments (usually corporate investment grade, high yield, and emerging market debt) of the public bond market, as such replacing part of the interest rate risk with higher levels of credit risk. This approach indeed reduces valuation risk from rising rates by investing in portfolios of typically shorter duration, and enhances bond returns by the respective credit spread. Further, instruments used are highly liquid, well established, and part of the traditional bond category from a regulatory perspective. Still, these effects are limited and positive correlation of credit risk typically dominant in the overall portfolio to equity risk can reduce diversification effects from investing in both equity and bond markets. In parallel to the national banks efforts to stimulate economies with low interest rates, the financial industry is facing more stringent regulation from local and supranational authorities, asking for stronger balance sheets to make banking systems more resilient to economic weakness. This encouraged banks to let institutional investors step in as providers of capital, thus strengthening their balance sheets. European Asset-backed Securities 1 and Bank Loans (also referred to as senior secured loans or leveraged loans ) are two segments within the non-traditional (or alternative ) investment universe, which gain attention in the current environment. Both are segments of the secured finance universe, but differ significantly in various aspects. Their characteristics, opportunities and risks are discussed in more detail in this paper. 1 While Mercer generally recommends investing in a globally diversified way, structural differences in European and US ABS have to be considered. These differences are briefly described in this paper. M E R C E R 1

SECURED FINANCE OVER VIEW Recently, a number of asset managers have launched secured finance, secured income, alternative credit or alternative income strategies. The majority of these funds are focused on the same objectives: Building a portfolio that delivers a higher level of secured cash flows that are relatively senior in the capital structure. The following graph shows an overview of different debt instruments within the credit universe. UND E R S T A N D I N G T H E C R E D IT S P E C T R U M Liquidity High Varies Moderate Low Complexity Low High Moderate Moderate Credit Quality High Relatively high Typically lower Relatively high Securitization Unsecured Secured Typically mixed Secured Picture 1: Secured Finance within the Credit Spectrum Many of these secured finance strategies have an emphasis on income as opposed to capital appreciation. We believe these types of products can have a valuable role to play as part of an investor s allocation to defensive assets or as part of a cashflow-driven financing strategy. However, some products look to achieve a higher return objective and these could equally fit into an investor s growth portfolio. Surprisingly enough, secured finance strategies typically achieve a pick-up in yield over unsecured corporate investment-grade credit equivalents. We think this is largely the result of compensation for a combination of illiquidity, complexity and scarcity risk premia. Compensation for illiquidity is broadly accepted, understood and exploited by institutional investors; for example, through an allocation to private market investments. Compensation for complexity, however, is less commonly recognized or exploited in traditional portfolios. Many of the underlying assets in a secured finance strategy are more complex to assess because of their structure or bespoke nature. Compensation for scarcity relates to the need for, and difficulty in, sourcing private transactions that are not as straightforward as purchasing public market bonds. M E R C E R 2

These premiums apply differently to each sub-asset class within the Secured Finance universe as shown in the table below. E X A M P L E S O F S E C U R E D F I N A N C E SUB- A S S E T C L A S S E S Asset Class Description Premium Liquidity / Term Public / Private Asset Backed Securities (ABS) Structured debt security based on and collateralized by a pool of typically secured consumer loans. Complexity High Liquidity Public Bank Loans Senior and secured floating rate debt structured, syndicated and administered by a bank. Illiquidity / Scarcity 3-5 Year Term Private Collateralized Loan Obligations (CLO) A tradable structured credit vehicle, backed by corporate loans. Principal and interest proceeds paid out in a series of prescribed tranches. (Often seen as part of ABS segment) Complexity High / Medium Liquidity Private Private Debt Direct lending to, often smaller and midsized, companies to finance acquisitions or expansions of existing profitable businesses. Occasionally those requiring restructuring expertise. Scarcity / Illiquidity 3-5 Year Term Private Real Estate & Infrastructure Debt Senior debt secured on commercial real estate or an infrastructure asset. Illiquidity / Scarcity 5-30 Year Term Private Trade Finance/ Receivables Trade Finance - short term loans to support the physical flow of goods between buyers and sellers. Receivables the sale at a discount of the claim to outstanding invoices on already delivered goods or services. Scarcity / Complexity 3-6 Month Term Private Specifically, asset-backed securities are a special case within the secured finance spectrum as they are publically traded and therefore highly liquid in normal market conditions. M E R C E R 3

CHARACTERISTICS OF E UROPEAN ASSET BACKED SECURITIES AN D BANK LOANS S T R U C T U R E O F A N A B S I N V E S T M E N T ABS are created by aggregating and repackaging pools of assets, including residential (RMBS) and commercial (CMBS) mortgages, consumer loans (credit card, student, auto) and corporate loans (CLOs). The underlying loans may have a variety of rate structures, are illiquid and can t be sold individually. A specifically created legal entity (Special Purpose Vehicle, SPV) buys the loans from the originator (typically a bank acting as the lender) and uses the loans as collateral for issuance of floating rate bonds. It then takes the cash-flows on these loans to repay interest and principal to their bond investors. Once these loans are held by the SPV, creditors of the originator have no further call upon the loans or their cash flows, so the SPV is bankruptcy-remote. Investors receive scheduled debt repayments from the diversified pool of underlying loans and assume the risk in the event of a borrower s default. Picture 2: Sample Structure of an Asset Backed Security (Residential Mortgage Backed Security) Asset-backed securities are therefore structured into bonds, listed on a securities exchange with a regulated market. They typically pay a floating rate coupon, keeping duration (and such interest rate risk) low. D I F F E R E N C E S B E T W E E N E U R O P E A N A N D U S R M B S Residential mortgage backed securities (RMBS) gained a bad reputation during the financial crisis, as US RMBS sourced from pools of mortgages to borrowers with low creditworthiness ( sub-prime mortgages ) were identified as one reason for the near collapse of the global financial system. There are however important differences between US and European mortgage backed securities, mainly in two areas: Sourcing of US mortgages was subject to less restrictive credit criteria than applied and often enforced by financial industry authorities in Europe. This included household income, down-payment limits and amortization schedules. Also, US lenders are limited to the financed real estate object in case of default, while European mortgage lenders have access M E R C E R 4

to the full current and future wealth of the borrower. Additionally, the stigma attached to a declaration of personal insolvency is far more severe in European societies, putting more pressure on borrowers in Europe to service their mortgages. Structuring of European RMBS includes different layers that help protect the holder of the RMBS from losses due to default of mortgage holders, including an alignment of interest between issuer and investor through a retained reserve fund, as the following graph illustrates. Such safety cushions were often sold to other investors in previous US structures rather than retained by the issuers. Picture 3: Illustrative Safety Cushions in European RMBS (Source: TwentyFour Asset Management; adapted) Additionally, the European residential housing market seems better diversified than the US housing market from what was experienced during the financial crisis: Despite material downturns in residential housing markets and increases in unemployment across the globe, European ABS was highly resilient. Markets which issued ABS experienced a low level of mortgage defaults, and ABS structures used were strong enough to cope with the experienced losses. Moody s estimates the 5- year cumulative default rate on global ABS to be 21% compared to below 1% for European ABS, while rating accuracy ratio was 54% for global ABS (i.e. almost every second rating was downgraded) compared to 87% for the European ABS during that period. This may help illustrate why an association of European ABS with the problems of the financial crisis does not seem justifiable from a factual point of view. M E R C E R 5

S T R U C T U R E O F A B A N K L O A N I N V E S T M E N T Bank Loans are a form of debt financing to a corporate, where the lender holds a legal claim to the borrower s assets above all other debt obligations. The originator is typically a bank, providing a loan to a corporate borrower. The bank then re-sells the loans to structure or strengthen its balance sheet. The graph below gives an overview of the structure of a bank loan: Picture 4: Sample Structure of a Bank Loan Bank Loans tend to be made to smaller corporations with no direct access to the bond market, or to corporations with a low credit rating. They are usually formed as senior debt with top priority for repayment in case of default of the borrower. While credit rating of the borrower is typically non-investment grade, Bank Loans are usually considered to be high-yield investments as well. Compared to a listed high-yield bond of the same borrower however, they provide additional security to the lender with specific assets pledged as collateral: Picture 5: Collateralization of Bank Loans Bank Loans are not structured and not exchange listed, providing a private market character with a limited secondary market only. They typically pay a floating rate coupon, keeping duration (and as such interest rate risk) low. Recent deals further include LIBOR floors, which are a valuable feature to investors at current low interest rate levels. M E R C E R 6

C O M P A R I S O N O F E U R O P E A N A B S A N D B A N K L O A N S The following table gives an overview of similarities and differences between European ABS and Bank Loans: Characteristic European ABS Bank Loan Borrower Originator Structuring / Securitization Rating Considerations Repayment Structure Investment Risks European ABS contain loans made to a large number of typically private borrowers. These loans cannot be sold individually. ABS are typically sourced by banks. The bank is re-selling the loans typically to finance rather than transfer risk from its balance sheet. Pools of loans are sold to a special purpose vehicle (SPV), which then issues bonds in different credit tranches. Safety cushions and lower rated tranches absorb losses before more senior tranches are affected, while senior tranches have priority for interest and principal repayment. Rating of an ABS is driven by likely default rates and loss severity within the underlying pool, taking into account the quality of the transaction structuring. Usually formed as floating rate bond (LIBOR plus fixed credit spread). Interest rate risk is low given their typically floating rate structure. However, rate increases may decrease the ability of borrowers to finance the underlying investments held within the ABS. Credit risk of an individual borrower is mitigated by borrower s equity and by diversification. Collateral default risk is mitigated by different credit tranches, but needs assessment on stochastic basis. Currency risk is dependent on whether a hedged implementation is chosen. Liquidity risk is typically low, but could be an issue in extreme market conditions. Bank Loans are loans made to a single corporation as senior debt on the corporate balance sheet. Bank Loans are typically sourced by banks. The bank is re-selling the loans to structure or strengthen its balance sheet. Individual loans of senior credit are sold to institutional investors (typically pooled vehicles like investment funds). Senior status ensures priority repayment in case of default, while specified assets pledged as collateral provide additional security to the lender. While the borrowers typically have a sub-investment grade rating, single loans do not get an official rating taking into account securitization measures. As such, Bank Loans are typically considered to be high yield. Usually formed as floating rate bond (LIBOR plus fixed credit spread). Interest rate risk is low given typically floating rate payments. However, rate increases may decrease the ability of borrowers to finance their loans. Credit risk is to be assessed on an individual loan basis. Securitization measures enhance credit rating, but liquidation of collateral is time and cost consuming. Currency risk is dependent on whether a hedged implementation is chosen. Liquidity risk is high, as Bank Loans are privately sold. Secondary markets are limited and might fall away completely in extreme market conditions. M E R C E R 7

Characteristic European ABS Bank Loan Implementation Considerations Underlying Market Swiss Pension Regulation A deep understanding of the underlying credit markets as well as of the structuring process and contracts is key to successful investment in the ABS market. This is usually achieved through a specialized asset manager. European ABS is sourced from residential and commercial mortgage backed securities, consumer loans and often commercial loans. RMBS is by far the largest type of ABS offered, while UK, Italy, Netherlands and Spain are significant issuing countries. ABS are considered an Alternative Investment according to BVV2. Analyzing borrower s credit risk and the legal terms of the loan contract are key elements to successfully invest in the Bank Loan market. This is usually achieved through a specialized asset manager. Bank Loans are typically well diversified over sectors, while regional allocation is typically tilted towards the USA, with Europe making up for much of the remainder of an investor s portfolio. Bank Loans are considered an Alternative Investment according to BVV2. M E R C E R 8

EUROPEAN ABS AND BANK LOANS HISTORICAL RESULTS In order to assess historical and prospective results of the two asset classes, the Bloomberg Barclays Euro Aggregate ABS index is used as a proxy for the European ABS market (shown in blue) and the S&P Global Leveraged Loan index is used as proxy for the global Bank Loan market (shown in green). Where applicable, the Bloomberg Barclays Euro Aggregate index is used as a bond proxy and the MSCI EMU index as an equity proxy, both for comparison. Two distinct time periods are further used for the analysis, the 9.5 years from 06/2007 to 12/2016 to include the financial crisis and the 7 years from 01/2010 to 12/2016 to exclude the 2008 turmoil and the 2009 recovery. All data is in shown in EUR, with the S&P Global Leveraged Loan index hedged into EUR to avoid any influence from cross currency fluctuations. H I S T O R I C A L R E T U R N S Below graphs show the cumulative return of bonds, equities, European ABS and Bank Loans over the specified periods: Over the longer period, bonds and European ABS outperformed, ahead of Bank Loans and equities. Results differ mainly due to results during the financial crisis, where equities and Bank Loans suffered significant losses, while bonds and European ABS remained stable. While we see similar results over the shorter period for all fixed income universes, equities outperformed notably, but with significantly higher levels of fluctuation risk. Picture 6: Historical Returns While the periods shown seem quite long, it is worthwhile to note that we have seen a special market situation in the aftermath of the financial crisis: While equities in Europe have experienced a M E R C E R 9

slow but steady recovery for most of the period (with more volatile market behavior starting only in 2015), bonds profited from interest rates being driven lower by stabilization measures of national banks to record low levels. Specifically comparison to bonds might look quite different in the future, should interest rates start to rise, resulting in lower valuations of (fixed interest) bonds, while European ABS and Bank Loans should be able to protect investments given their floating rate nature. In order to understand the loss and recovery characteristics of each asset class, charts below show the cumulative drawdown for the same proxies over the same periods: Unsurprisingly, equities posted the largest losses during the financial crisis at over 50%, but also Bank Loans suffered a 30% decline. Unlike equities however, Bank Loans recovered quite quickly from their losses. Drawdowns of bonds and European ABS were significantly lower. Excluding the financial crisis, equities still stand out with significant drawdowns, followed by Bank Loans, Bonds and European ABS. Maximum drawdown for Bank Loans over this period is around 6%, while Bonds and European ABS stood at just over 4%. Picture 7: Historical Draw-downs The difference between Bank Loans and European ABS during the financial crisis is attributable to the liquidity of the asset class: While European ABS profited from an open and regulated market, individual Bank Loans were typically held by only a small number of investors, and some of these specifically hedge funds were forced to sell into an illiquid market when credit lines were cancelled by their banks. The fact that these losses did not mainly result from default of borrowers is reflected in the speed of recovery. Bank Loans reached their previous price levels by the end of 2009, while equities reached theirs only in 2015. M E R C E R 10

H I S T O R I C A L R I S K / R E T U R N C O N S I D E R A T I O N S Below graphs show the risk/return characteristics of European ABS and Bank Loans compared to bonds and equities: European ABS shows great stability with an annualized volatility of around 3%, even lower than the bond index. Bank Loans figure is over 9% reflecting the decline and recovery during the financial crisis, while volatility for equities is 18%. Calculated since 2010, both European ABS and Bank Loans report figures in line with bonds. Again, ABS is lowest with 3%, while Bank Loans stand between 4 and 5%. Volatility for equities is over 15% even for the shorter period. Picture 8: Risk-/Return Characteristics Over the past 7 years, a clear distinction between fixed income and equities can be shown with volatility and return figures for European ABS, Bank Loans and bonds in the same area. In contrast, Bank Loans exhibit significantly higher volatility than bonds and European ABS when including the financial crisis in 2008 due to low market liquidity. M E R C E R 11

Below graphs show the rolling 3-year correlations of European ABS and Bank Loans with the above referenced bond and equity indices: When looking at correlations to bonds, Bank Loans were mainly uncorrelated, while European ABS showed quite high correlations for most of the period, but trending lower recently when interest rates stopped going down further. Should interest rates start to rise, lower correlations are expected due to the short duration of both European ABS and Bank Loans. In contrast, Bank Loans exhibited higher correlations to equities than European ABS, which look mainly uncorrelated. The slow and steady recovery of the equity market may have added to higher than normal correlations. Still, illiquidity might remain an aspect of equity correlations for Bank Loans. Picture 9: Correlations to Bonds and Equities H I S T O R I C A L P O R T F O L I O C O N S I D E R A T I O N S While the analyses above look at each asset class separately, the graphs below illustrate how relatively small investments in European ABS and Bank Loans can improve the risk/return characteristics of a balanced portfolio. The starting point for this analysis is a 50% bond / 50% equity portfolio, built with the same indices as used before. Then, bond and equity share is reduced to 45% each, including either 10% European ABS, 10% Bank Loans or 5% each of European ABS and Bank Loans. M E R C E R 12

Resulting risk/return characteristics are shown in the following graphs, calculated again over a 9.5 and a 7 year period ending December 2016 and using monthly rebalancing: Over the longer period, a standard 50/50 portfolio (red rectangle) reached an annualized return of 3.7% at a volatility of 9.4%. Diversification with 10% secured finance instruments led to a reduction of the overall portfolio volatility of between 0.8% (European ABS) and 0.3% (Bank Loans) with no notable reduction in investment return. Calculated over 7 years, overall portfolio volatility is reduced between 0.5% and 0.8% with no notable reduction in return, despite reducing (outperforming) equities by 5%. Picture 10: Diversification in a Portfolio Context European ABS and Bank Loans were able to increase the efficiency of institutional balanced portfolios in the past, by lowering overall portfolio volatility between 0.3% and 0.8% through replacing 5% bonds and equities each. This could be shown for a period with bond outperforming equities (including the financial crisis), and for a period with equities outperforming bonds (since 2010). Assuming a period of rising interest rates, an additional positive effect is expected from a reduction of fixed interest bonds with floating rate secured finance instruments. M E R C E R 13

CONCLUSIONS With an attractive spread over LIBOR and with very low interest rate sensitivity due to their floating rate nature, European ABS and Bank Loans are both interesting options to diversify institutional balanced portfolios. Due to structural differences, we prefer European ABS over US ABS for European investors, while investing in Bank Loans should be on a global basis for better diversification. Historical data is convincing, but investors in European ABS and Bank Loans should still be aware of the following potential tail risks: A strong surge in interest rates could be negative for both asset classes, should servicing their loans become a problem for borrowers on a broader basis. Bank Loans are illiquid by nature. Should liquidity in the loan market dry out (as experienced in 2008) at least temporary losses are likely. The European ABS market is tilted towards residential mortgages, and a broad and deep real estate market correction (exceeding financial crisis levels) might lead to losses. Note that both asset classes are considered Alternative Investments according to Swiss pension fund regulations (LPP2). Structurally, both European ABS and Bank Loans profit from the pledging of assets of the borrower to the lender, providing an increased safety level for the investor. In the case of Bank Loans, this pledge is coming into play in case of default, which has historically resulted in significantly higher recovery rates than for (unsecured) high-yield bonds. European ABS profits from safety cushions built into the structure of the ABS, thus avoiding default at the investor level in the first place. Their structuring also includes an alignment of interest between issuer and investor, as the issuer typically keeps the most junior tranche. European ABS, offering access to the usually not covered consumer debt market, posted attractive returns with low levels of risk, as measured by volatility and by drawdown. It is worth noting that there has been little impact from the financial crisis in 2008, as defaults of European home-owners were limited and liquidity in these listed instruments remained acceptable. Correlations to equities remained low over the past 9 years, while correlations to bonds were higher. We would however not be surprised to see correlations to bonds come down in periods of rising interest rates. Bank Loans suffered from their illiquid nature during the financial crisis, but regained their 30% loss relatively quickly when liquidity returned to the credit markets, proving that defaults stayed limited. Since 2010, return and volatility levels have been comparable to European ABS, while correlation to bonds has been lower and correlation to equities has been higher. We would expect correlation to equities to stay higher, as corporate credit risk and illiquidity is linked to general economic and corporate developments. In a portfolio context, both European ABS and Bank Loans were able to diversify overall portfolio volatility without affecting portfolio returns. This was measured during periods of predominantly falling interest rates, benefitting fixed interest rate bonds. Should interest rates start to rise, we would expect to see an additional capital protection from these floating rate based instruments. M E R C E R 14

When implementing investments in secured finance asset classes, hedging currency risk seems to be a safe choice for Swiss institutional investors given on-going dislocations due to national banks divergent implementation of fiscal and monetary policy, and despite rising interest rate differentials (especially to the USD) that make hedging more expensive. Finally, both asset classes require specialist knowledge of both markets and individual transactions. Thus we recommend diversified implementation with experienced managers in each field. M E R C E R 15

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