Click here to listen to Part One

Karthik Narayanan, Head of Structured Credit, joins Macro Markets for a two-part episode that addresses the fundamental appeal of the sector, its relative and absolute value, and where we are finding opportunity and risk today. In Part 2, we discuss where we are finding value and risk in today’s market.

This transcript is computer-generated and may contain inaccuracies.

Jay Diamond: Hi everybody, and welcome to part two of our discussion of Structured Credit. In part one we address the fundamentals of structured credit investing, how it has become such an important differentiator for our approach to active fixed income investing, and why we believe this sector is attractive on an absolute and relative basis. Part two digs deeper into the opportunity set and risks and current market conditions. I’m Jay Diamond, head of thought leadership for Guggenheim Investments. And back with me again is Karthik Narayanan, Head of our Structured Credit Team. With that, let’s get started with part two. Karthik welcome back. So in part one of this episode you discussed the breadth of the structured credit market. So, to begin, walk us through the market dynamics in the important subsectors of structured credit and where you are seeing value right now.

Karthik Narayanan: What we find in structured credit, and this is true of all bond investing in general, you need a favorable intersection between valuation and fundamentals. Technical factors may affect your timing, but as a long-term, credit-oriented credit-first-type investor, we want to be comfortable with the intersection of valuation and fundamentals. And not all sectors is going to check all those boxes all the time, which highlights the importance of being involved in all these markets, even if the opportunities are limited at a given point in time, because that’ll change. So let’s just go around the horn and talk about the four major sectors and sort of what we see going on there. So first is ABS. So within the ABS market there’s really two major flavors. There’s one consumer ABS, which is about 60ish percent of the overall $750 billion ABS market. These are deals where the obligor are individual consumers: think auto loans, unsecured personal loans, student loans. Now the other 35 to 40 percent is what we call commercial abs. Sometimes people call it esoteric ABS, but I prefer the term commercial ABS. And really it’s called commercial abs because the obligor, is a commercial entity or contracts originated to a commercial entity. So examples of this might include royalty backed ABS, where the contractual claim is on royalties that are derived from intellectual property. It could be on music royalties, on franchise restaurant royalties. It could be cash flows generated by leases on operating assets such as rail cars, aircraft, etc. It could be digital infrastructure, it can be leases of data centers, any of those things. These all fall under the category of commercial ABS, which itself is a subset, so call it 40 percent of the overall ABS market. So, a subset within a subset, and where we see value here right now is in a few places. One is in these royalty backed ABS deals, two is in data center backed in digital infrastructure back deals, it could be on optical fiber networks, cell towers, data centers as well as in aircraft ABS in some selected fund finance deals. So these are scalable pockets to a degree. They’re scalable, at sort of the portfolio scale we’re talking about, which is good for us. They’re not infinitely scalable. But they’re not so small that they’re not accessible in an institutional scale. Now, within this market, generally, the senior most first priority classes of these deals have maturities in the, let’s say, 5-to-7-year range. They’re typically singly or triple-B rated and these are coming to the market between a 5.5 percent and a 6.5 percent yield right now. So, if we step back and say these, and based on our belief and our analysis, that these are generally loss-remote instruments, they’re investment grade rated, their loss remote based on independent work we’re doing as investors in our capacity, you’re talking about 5.5 percent to 6.5 percent yield in a world where corporate bonds are yielding 4.75 for similar and actually, maybe marginally lower than that for, the same kind of duration. Now, if we want to take more risk and go below the investment grade graded part of the ABS market, this is an even smaller market. But their yields can approach 8 percent or 9 percent. So those are more selected opportunities that we avail ourselves of on occasion for higher risk tolerant strategies. But those opportunities exist as well. So really, commercially this is giving us some pretty meaningful additional yield with a lot of credit diversity. It’s one of our higher conviction areas right now.

Jay Diamond: What are you seeing in residential mortgage-backed securities?

Karthik Narayanan: So, speaking of other higher conviction areas, residential mortgages is one of our other, higher conviction areas. And really, the case for residential mortgages begins with the borrower. If you think of U.S. home prices, they have more than doubled over the past decade. Post GFC underwriting reforms are still in place. Those acted to strengthen loan quality, and the subsequent buildup in home prices results in homeowner equity that’s something like four times the amount of debt that’s outstanding. So, the equity that homeowners hold is four times the debt that they owe. So, this is a real key change from before the financial crisis, where that ratio was like 1 to 1 debt to equity. So, from a lender’s perspective, this market is under levered. And that equity cushion means that home prices would have to fall a long way before investment grade debt starts to bear any kind of losses. And second point on residential is, is, the lock-in effect And what that does for callability. Normally borrowers build up their equity, they’ll refinance, they’ll take out a bigger loan. But in today’s mortgage rate world, a lot of homeowners are sitting on very low mortgage rates with a lot of built up equity and have very, a big disincentive from losing that initial mortgage rate and going into a six-point-something percent current mortgage versus a 3 percent mortgage that they may have. So, a lot of what we’re starting to see is an increase in home equity lines of credit and closed-end second lien origination. It’s very small, but we expect it to grow. And it’s addressing this sort of under-leverage problem that exists in terms of wealth extraction in the home equity market.  Now, from a lender standpoint, how is that a good thing by reducing equity? Well, it’s fine if it’s at a prudent level, which we think there’s a lot of room to run there. But really, what the interesting thing that happens here is that these loans are not very callable. So usually when you talk about agency mortgages or jumbo mortgages, they’re incredibly sensitive to interest rates. And as an investor you have to factor that into the yield you will accept on these instruments. With some of these type of emerging mortgage types like closed-end seconds or non-qualified mortgages, the callability is much more suppressed. So, those are really two fundamental factors we like here.  Now, credit standards I mentioned have tightened a lot since the GFC era. And in fact, they’ve actually tightened even more in the last one or two years. So, we’re seeing credit scores on some of the non-Agency mortgage loans which are not gone to the same standard down the fairway underwriting as the agency eligible loans. So obviously there’s additional requirements that are needed there and credit enhancement that we and other investors will demand. But actually credit standards, when you look at credit scores and, and loan-to-value ratios have actually been improving even further. So, the credit story is good. The valuation story is good. We don’t think the call ability difference is or fully priced in the market. And it makes residential mortgages one of our other higher conviction trades and structured credit.

Jay Diamond: Let’s move on to other areas in the structure credit universe. What are you seeing in CLOs or collateralized loan obligations?

Karthik Narayanan: This is more of a mixed bag. Well, constructive on certain parts of the market. We’re cautious on others. Now, the macro market backdrop for credit in general is supportive and for CLOs as well. Some delay in fed cuts could improve the carry profile for CLOS. It keeps floating rate paper attractive. The market stays bid. And traditionally the largest buyer of senior CLO tranches which are banks are likely to improve their participation over time as some of the regulatory frameworks are sort of finalized, they’re very close to that at this point. There’s increasing demand from ETFs and other, investment strategies in CLOs. And if we look at just trading volume in CLOs, it’s running something like 50 percent ahead of where it was last year. So definitely a lot of activity in this market. Now on the underlying loan side, we talked about wanting to think about an intersection of fundamentals as well as valuation. On the fundamental loan side, at the aggregate level, loans are doing okay. But what we’re really more keeping our finger on the pulse is elevated dispersion in the tails. And that’s really driven by, as what our listeners know, has come into the market in the form of AI disruption risk to software and technology businesses that comprise something like 13 percent of the leveraged loan market, which is the underlying collateral for see of CLOs. So, in January, the overall loan market was trading at about 96.5 cents on the dollar. When a lot of this narrative kicked in, the on conflict began, the overall market sold off to about $0.94 on the dollar. And then it’s rallied about halfway back at this point to about 95, and a half cents. So, this journey created a lot of dispersion in underlying loans, which is important if you’re investing directly in loans. It’s important if you are an investor in junior CLO tranches. And those are areas where we’re cautious. But it is less important for the investment grade tranches of CLOs. Research generally shows that that loan prices, once they go below about 80, it’s a pretty good indicator of short-term defaults. To start the year, the loan market had something like 3.5 percent of loans trading below 80. That number is something like 6.5 percent now. And back then in January, 10 percent of those loans were software companies; now about a third of them are. So, the market is pricing in some amount of distress in that world, and it’s going to take some time to play out. But that dispersion is going to put pressure on parts of the CLO market, particularly on deals that are already outstanding, as opposed to new deals where managers have flexibility to select for different types of collateral, can select away from those types of distressed sectors, which I know my colleagues on the corporate side have been doing actively. So where does that leave us? In CLOs it’s really in positioning in single-A and higher tranches where we stress test these two Great Depression type default rates. And these tranches recover full principal in those scenarios. And we’re earning a 100-plus basis points above comparable, comparably rated corporate bonds for what is sort of loss remote type profiles. So that’s really where we’re spending time on CLOs.

Jay Diamond: Karthick to wrap up our tour of the four major sectors of structured credit, what is your view of opportunities in commercial mortgage-backed securities or CMBS?

Karthik Narayanan: We think this market is turning a corner and kind of entering a new phase. We’ve seen a big rebound in securitization issuance. It’s being met by a lot of healthy investor demand. We’re seeing on the underlying loans, especially office loans where there’s been a lot of distress, work out timelines of probably peaked and they’re starting to shorten. And then, we’re seeing the rate at which new distressed loans are going in special servicing is actually falling below the rate at which loans are coming out of workout. So the market sort of entering a new phase of clearing these distressed loans, but there’s still a ways to go.  And it’s really amounting to a tale of two markets. One for legacy assets that don’t have visible business plans. Maybe not repositionable without significant capital injection. Maybe backed by loans that then are difficult to formulate a resolution. That’s those problem assets both in the commercial real estate market as well as in CMBS. And then there’s another part of the two markets is in for, is in assets where there is a clear business plan, there are visible valuations and comparables, and you are able to secure financing in today’s market. So really is a huge bifurcation in both the underlying real estate as well as in the debt market for CMBS. So we are cautious on seasoned junior CMBS where the outcomes can be very binary. And we’ve found better opportunities in commercial real estate-backed CLOs, which are primarily backed by multifamily properties that are undergoing some amount of transition. We think these deals—and we tend to focus on deals with capable sponsors and operators—it’s a small market. It’s not infinitely scalable, though scalable enough. And there’s significant credit enhancement here in prudent underwriting. So that’s really where we’ve been focused in CMBS.

Jay Diamond: So, Karthik, you mentioned loss remote. What does that actually mean?

Karthik Narayanan: S