Macro Markets Podcast Episode 48: Why We Like Structured Credit

Karthik Narayanan and Danny Gibbs give an overview of the structured credit market.

February 20, 2024


Macro Markets Podcast Episode 48: Why We Like Structured Credit

Karthik Narayanan, Head of Structured Credit for Guggenheim Investments, and Danny Gibbs, a portfolio manager on our Total Return team, join Macro Markets to give an overview of the structured credit market.

This transcript is computer-generated and may contain inaccuracies.

Jay Diamond: Hi everybody and welcome to the Macro Markets with Guggenheim Investments, where we invite leaders from our investment team to offer their analysis of the investment landscape and the economic outlook. I'm Jay Diamond, head of Thought Leadership for Guggenheim Investments, and I'll be hosting today. We are recording this episode on Wednesday, February 14th, 2024. Now, before we begin, I want to thank our listeners for tuning in and remind you that if you have any questions for our podcast guests, please email us at macromarkets@guggenheiminvestments.com. Okay. Now we are watching markets scramble to re-assess the outlook for the next steps in the Fed's execution of policy, which is resulting in a lot of volatility. This week's hot CPI release, combined with a strong January jobs report and a more emphatic wait-and-see stance from the Federal Reserve (“Fed”) has pushed back expectations for the first rate cut in this policy cycle, causing a backup in yields across the curve and some bloody days for stocks. In times of short-term volatility like this, maintaining a long-term strategy is important for investors. For us, this long-term focus means looking for relative value opportunities in undervalued or complex parts of the fixed income markets, which typically leads us to structured credit. Structured credit encompasses asset-backed securities, collateralized loan obligations and mortgage-backed securities. Now, here to discuss this sector and how our investment process works, are two of our investment team leaders, Karthik Narayanan, head of Structured Credit for Guggenheim Investments, and Danny Gibbs, a portfolio manager on our Total Return team. Happy Valentine's Day, Karthik and Danny, and thanks for taking the time to chat with us today.

Karthik Narayanan: Thanks, Jay. Happy to be here.

Danny Gibbs: Thanks, Jay. Same to you.

Jay Diamond: Now, Karthik and Danny, let's start with some basics about our firm and how we execute our investment process. Now, in our firm's investment process, the sector teams and the portfolio management teams are separate but interdependent. How does this work in practice? Karthik, why don't you start?

Karthik Narayanan: It is a unique aspect among investment firms and so I'll be happy to discuss that. The easiest way to think about the delineation of responsibilities between sector teams and portfolio management teams is to think about the sector teams being responsible for interfacing with dealers, staying abreast of the market and industry fundamentals, and ultimately finding filtering and analyzing investment opportunities. So, it's more of a market-oriented interfacing function. Now, this is done in a manner that's relatively independent and agnostic to portfolio strategy or individual client mandates, and that's done on purpose. And it's so that the sector teams can target the broadest possible opportunity set without any level of self-censoring that would go on if the objective function was being set by an individual strategy or mandate. Why we do this should be obvious to many of your listeners, tracing back to basic economic fundamentals of division of labor and specialization as was talked about in Adam Smith and the benefits to the concept of a firm. Moving away from that and thinking about what that specialization and delinking of responsibilities buys us, we have to think a little bit about behavioral finance and psychology. Now, sector teams, by nature of the way they're set up, are going to be the closest to the assets. They're going to be closest to the investments. And oftentimes what can happen is this idea of familiarity bias, where because an individual analyst or trader is very familiar with a sector, they may lose objectivity, and by removing some of the decision-making from the sector team and placing it with the portfolio management team, which Danny will talk about minute, we strive to maintain that objectivity. So just to recap, sector teams are funneling in all the ideas in the market, applying a credit filter and an underwriting and stress testing framework, and then the investments that pass all those rigors are then available for portfolio managers to consider for a variety of strategies with the idea of being that we're reducing bias in decision-making.

Jay Diamond: So Danny, tell us about the portfolio managers in this process.

Danny Gibbs: From a very high level, when you boil down the role of the portfolio manager (“PM’), it's really to try and marry together all of the actual outputs from the other three teams involved in the investment process. So, the outputs coming from the sector team, which is going to be, as Karthik described, this universe of credit eligible bonds for us to actually pick from, the top-down views coming from the Macroeconomic Research team, and finally, the actual design of the portfolio, which comes from the Portfolio Construction Group. They're trying to fit these all together in a cohesive manner across all of the different portfolios and funds that we manage. So, I guess more specifically, what we're actually doing or what our responsibility is, particularly as it applies to the sector team, is piecing together the portfolios bond-by-bond from this universe of credit approved securities and loans and such. The end goal is to construct a well-diversified portfolio that's at the end of the day, in line with the actual general parameters coming from the Portfolio Construction Group, with the end goal being to design a portfolio that can weather a multitude of market environments, minimize tail risks, all while achieving the actual individual client's return and risk objectives.

Jay Diamond: Now Karthik, for our newer listeners, would you mind running through for us the basic characteristics and structures of asset-backed securities, or as we call the sector, structured credit.

Karthik Narayanan: So, structured credit, first off, is a $3 trillion fixed income credit market, and there are four main sectors: ABS or asset backed securities, CLOs or collateralized loan obligations, residential mortgage-backed securities, and commercial mortgage-backed securities. But cutting through that obvious complexity, there's a few things that I want to leave our listeners with that would be helpful in their travels in and around the structured credit market. Now, first, we're talking about structured credit as though it is a single asset class. It's not a single asset class. It's not even the four asset classes. It's really a technology. It's a technology for secured lending on financial contracts and assets, so that can be applied across a wide swath of the economy. Now, when you think about that, like corporate bonds, where investors effectively lend money to an operating business and have a promise of that business to pay back the money at a point in the future with interest along the way, similarly structured credit is a way for investors to lend money on a pool of real or financial assets that have contractual cash flows and earn a return along the way. So, it's a technology, it's a format of lending. Second point I'd want to leave our listeners with is that structured credit is what we call secured lending, and first and foremost, it's secured by contractual cash flows. So, for example, an ABS deal, an asset-backed securities deal, which is a subsector of structured credit, maybe backed by a pool of lease payments. Leases are by definition of financial contract, and they're scheduled payments that are predictable. And absent some defaults and other sort of rare conditions, the cash flows are pretty well predictable. Now, secondarily, in addition to those contractual cash flows, structured credit investments are secured by a pledge of assets. So, if we take a different example of residential mortgage-backed securities or RMBS, the contractual cash flows are the mortgages. The mortgages require the homeowner that's taking out the loan to pay on a monthly basis interest and principal, so that's the contractual cash flow, but if they cannot make good on that cash flow, there's also a pledge of assets in the form of the underlying property. So, there's sort of this double barrel underlying source of value, which is one, contractual cash flows, and two, assets. So, the next point about structured credit that I want to impress upon our listeners is because this is a technology that applies over the entire swath of the economy, it's a very diverse market. If you think about the various asset types that appear in structured credit, whether it's residential mortgages, or leases on cars, or leases on shipping containers, or leases on data centers, or auto loans, or commercial loans, these are very diverse parts of the economy. They have different underlying drivers. It brings a level of diversification to the market. So that point is really that there's diversity within this market. It's not homogeneous. The next thing is that structured credit provides a couple of structural terms that we think are favorable and motivate our participation in the market. One is incentive alignment. So, in a structured credit transaction, the sponsor of the transaction or the party that's ultimately borrowing the money has to retain some of the risk in the securitization. And what that means is that there's some incentive alignment between the borrower and the lender. The next point is that there's something that we call credit enhancement, and that's sort of a catch-all term, and at a high level, what it means is there's different technologies employed in these structured credit deals to insulate lenders from losses on the underlying collateral. That can come in different forms, whether it's something we call principal subordination or excess interest. There's very specific technologies that are used there, but the net effect is that it provides some insulation to lenders against losses that would occur on the underlying collateral. There are also structural protections and bondholder protections. These are aspects such as test and triggers that monitor the performance of the collateral underlying the structured credit deal. And those tests and triggers serve to shunt cash flows or change the rights of the different parties under certain circumstances in order to protect lenders and investors.

Jay Diamond: Thank you very much for that deep dive. Why does our firm like to include structured credit in our portfolios in general?

Karthik Narayanan: Structured credit is a part of the market that we've been involved with since the inception of the firm, and it's been a core focus area within our multi-sector portfolios over the years. As we discussed, structured credit is discussed as a single asset class, but it's really a technology that's very diverse in the underlying economic exposures and parts of the market that it touches. Now, diversity would be characterized as a good thing from a portfolio standpoint as a way to optimize return relative to risk, but the other side of the diversity coin is that it makes the market complex. And that represents a barrier to entry, and because of that barrier to entry, we find consistently in structured credit that there are excess yields relative to credit rating compared to corporate bonds. So, for the same level of credit rating as a proxy for credit risk, yields are higher in structured credit, and that's pretty persistent overtime. The magnitude changes, but that complexity premium has been persistent. And the second thing is, as we mentioned earlier, structured credit is secured lending, it's secured by contractual cash flows as well as assets. Because it's secured by contractual cash flows, the tenor or the maturity of structured credit bonds does not tend to be that long relative to say, corporate credit or municipal bonds or government bonds, which can be much longer, 10, 20, 30 years maturity. Structured credit, the vast majority of the market has between 3-to-7-year average lives or average maturity, so they tend to be shorter tenor. Now, what is the value of that for portfolio construction and investment focus? Well, it tends to reduce the amount of mark to market volatility that you'll see in the market because that is proportionate to the duration or the interest rate sensitivity of a bond, and bonds with lower duration or shorter maturities tend to be less volatile from a total return standpoint that bonds with longer maturity. So, both the higher income for a given level of credit rating as well as the lower prospective mark to market volatility are two of the primary reasons that we've been attracted to this market over time, in addition to all the credit support and structural safeguards that I mentioned a moment ago, which are very critical from a bottom-up security selection standpoint.

Jay Diamond: Now, thank you, Karthik. Now Danny, Karthik just told us why in general our firm favors structured credit, but why do we like structured credit now?

Danny Gibbs: It's obviously an asset class that we've favored historically, but there are a couple of reasons why it looks particularly attractive right now. As Karthik already kind of went through, there's generally always a yield advantage to structured credit versus other more conventional fixed income asset classes, and a lot of this comes from that complexity premium that Karthik described. To put that premium into historical context, one reference set that we generally use is the Bank of America ABS AA-BBB index, which it's not perfect, but it's going to capture a lot of the commercial ABS universe that we like to play in. That premium versus the Bloomberg IG Index, for example, has historically been closer to about 50 basis points, but currently that sits closer to about 125 basis points, so you're collecting a pretty significant premium to invest in ABS at the moment. Another reason why that yield premium existed in the past has been just the one structural element of structured credit is generally the bonds have some type of call feature, so the issuer of the bonds is able to pull back the bonds in a market environment where either yields have dropped or spreads have tightened. And in order to award the lender for selling away that optionality, structured credit has historically traded with a higher coupon or more of a yield advantage versus corporate credit. The reason why I bring up that dynamic now is we obviously saw yields rise pretty dramatically over the last couple of years. So, if you look at the bonds present in the secondary market for structured credit, they obviously have much lower coupon and consequently trade with lower dollar prices. This is important in that context of callability in the sense that these bonds are pretty far out of the money from that call option. So as an investor or as a lender, you're still getting paid for selling away this optionality, but that optionality is much less in the money than it has been historically. From a convexity perspective, structured credit looks a lot closer to what investment grade corporates look like, but you're still getting paid that yield premium.

Jay Diamond:  Just to follow up, right now, we're seeing a lot of uncertainty about the macroeconomic backdrop. How big a driver right now of value is what we're seeing in the economy?

Danny Gibbs: Well, I think that's kind of the final point. One of the big pieces of the portfolio management role is really risk management. And when you get yourself into times like this, where it’s certainly more tumultuous and volatilities elevated across different asset classes, financial conditions are tighter, it kind of brings into question whether the old Fed pot is still at play right now. Simply speaking, your tail risks are fatter. And as Karthik highlighted, there's a couple of different features within structured credit that provide a really easy way for investors to diversify away this risk. One is just the actual end industries that you're investing in in structure credit are so different in nature that you do kind of have this ballast effect within structured credit in the fact that you're exposed to so many different end industries. In past cycles, as you've seen, any type of credit event generally starts in a specific industry and ripples out. By being invested across a vast array of industries through structured credit, you're flattening out that risk somewhat. Then the second element would be just the structural element of investing in structured credit. By investing higher in the capital structure, you're able to chop off that left tail risk to your underlying collateral. So that just a simple example, if you're investing in the most senior tranche in a CLO, so if you're investing in the AAA tranche of a CLO, you generally have about 35 percent credit enhancement. What that means is of the underlying pool of bank loans that make up the deal, you could see 35 percent of the bank loans default and recover zero before you actually start to face any type of loss in your actual bond. So, zooming out and thinking about what that means in an environment with fatter tails, you've already kind of diversified away that risk. You've chopped off that left 35 percent on a bottom performing distribution of your collateral just by investing higher in the capital structure.

Jay Diamond:  Now, Karthik, to follow up on Danny's comment, our Macro Team is calling for an economic slowdown as the aggressive rate hikes over the past two years start to bite. Now, structured credit isn't like corporate credit—we don't get 10 Ks and 10 Qs, or financial statements to evaluate. So how does the structure credit team evaluate and analyze credit quality for structured credit?

Karthik Narayanan: Credit quality within structured credit is evaluated in a bottom-up manner, considering what I would call the three pillars of this market, which are 1) collateral, 2) structure, and 3) key parties. So going through those individually, structured credit is a format of secured lending that's collateralized by contractual cash flows, as well as assets. Because there are contractual cash flows in assets, the first question is what are they worth, how would they perform through a cycle, and what is the variation around their expected performance? So, the collateral is the first element of the credit analysis. And information is available through the marketing of individual transactions. There's a lot of information that has to be gleaned through proprietary primary credit research on how the collateral is created and the commercial context in which it exists and the industry in which it exists. So, all of that work goes into analyzing the collateral and how it could cycle through time. The second is structure, and when you say structured credit, this is what everyone thinks of as 500-page indentures and payment priorities and legalese. Certainly true—that is the backbone of this market—but what we try to do in how we approach the market is to break down the components of those documents around important economic concepts. And so therefore, if we try to keep some degree of commonality to make sure we're checking all the boxes. With the structures, we're looking at what is commonly called the waterfall or the payment priority, so the order in which the cash received from the underlying collateral is distributed to investors. So, the priority matters. We're looking at that. We're looking at credit enhancement. How is it computed? What form does it come in? How might it go away? How much protection does it give you? We're looking at bondholder protections which are in the form of test triggers that may result in changing of rights or diversion of cash flows in order to protect investors under duress or exigent conditions. And we're looking at the ability to dispose of the collateral, if need be, to pay back the debt. And then finally, it's the key parties, servicers, collateral managers. Who are they? Are they noteworthy who reputable operators in the industry, do they have certain markets or niches that they operate in? If one of the key parties were to cease doing business or go away, would there be a reasonable commercial expectation of another party being able to take over that role or responsibility, or would it be disruptive and the contingent what ifs that go with that? So collateral, structure, and key parties. Those are the three bottom-up credit tenets that we're addressing. Now Jay, to your point, there are no Ks and Qs in this world. What we do have our trustee reports, or remittance statements, or collateral manager reports, and those are published on a monthly or quarterly basis, and they provide investors with a snapshot of how the collateral is performing, what the monies were that were collected over the period, the status of tests and triggers in the deal, and other statistical information about the collateral.

Jay Diamond: If I'm not mistaken, the credit performance of structured credit has done relatively well through times of economic and fiscal crisis. Isn't that correct?

Karthik Narayanan:That's right. And actually, if you look at on a long-term basis, what the rate of downgrades have been for investment-grade corporate bonds and investment-grade ABS, ABS has shown to be more rating stable historically. So, I think that's one way to test that hypothesis. And what we've seen in practice is similar where there's enough protections baked into the structuring of the deal, the sizing of the debt, the placement of bondholder protections that, of course, in any segment of the economy, there's going to be bumps in the road, but the idea is that these deals should be—and most of the time they have been—structured to weather those bumps.

Jay Diamond: Danny, I want to get back to something you mentioned before, because, again, Karthik is focused on his market, his sector, but you're looking at all sectors in constructing portfolios. And you said before that structure credit typically out-yields similarly rated corporate credit, but they're right now the difference in yields is wider than usual in general. Why is this the case and why is the spread wider than usual now?

Danny Gibbs: There are a few reasons why structured credit generally trades wide to corporate credit. Some are more justifiable in my mind than others. A classic example that we've come across or heard anecdotally is investors just kind of refusing to look at the sector, which results in less active participants in the asset class., and consequently, I guess you could argue are less efficient market. Some of this aversion comes from the actual workload involved in the asset class, which I think you can probably take away from Karthik's segment that hat's a very real element. It takes a lot of manpower from credit analysts, legal teams, traders that are proper presence in the actual space, and some firms have just made a calculated decision that they're either unwilling or unable to invest in these resources and have just found it easier to avoid the sector altogether. The second one, which in my mind is probably less defensible, is investors are still suffering from a structured credit hangover from the financial crisis. The fact of the matter is the broader asset class has changed pretty dramatically since the financial crisis. We have better structural protections today, better alignment between sponsors, structures, arrangers and lenders that have either eliminated or at the very least, material decreased some of the bad actor events that took place in the financial crisis. So, I don't give a ton of credence to that as a reason to avoid the asset class. And then another one, which is more technical and we kind of touched on it earlier, is a lot of sectors within structured credit either have hard calls, so meaning that they're callable at a price of 100. So, you generally don't see the ability of the bond or CLO or whatever it is to appreciate beyond that dollar price, which is different than what you see in the investment-grade corporate market. So, the investment-grade corporate market generally is in callable or has a very, very short-term call right near the maturity. And this allows for a bond to trade above $100 price. So more total return-oriented investors may look at that as a more attractive feature. But again, highlighting the dynamic that we have in the market currently, there's a ton of structured credit that was issued over the past four or five years that trade with lower coupons and as a result have lower dollar prices. So that kind of total return justification has kind of been flattened out between structured credit and corporate credit. The reason why we're seeing structured credit trade particularly wide to corporate credit at this current moment in time is mostly a result of the lagging nature that we've seen in structured credit historically. So, this is a dynamic that we saw at the end of 2022. We saw it in parts of the recovery coming out of COVID. But generally speaking, you are going to see credit spreads and yields in structured credit lagged that of corporate credit. So, we saw a very strong rally to the end of last year and some of the higher beta parts of the fixed income market, notably Agency RMBS, and investment grade corporates. Structured credit, however, more or less stayed flat on a dollar price basis, and when you look at the move that you saw on the yield curve, the implied spread move in structured credit, the fact that they stayed flat on a dollar price basis means that the implied spread move was wider. So, anytime we see this dynamic where we see a very quick repricing in credit spreads, particularly when credit spreads are moving in the same direction as yield, so both yields moved lower pretty quickly and credit spreads move tighter, structured credit is generally going to lag in performance. And what we've seen in the past is it takes a quarter or two for them to actually catch up. So that's the environment that we're looking at right now and it's a reason why we think the go forward potential return for structure credit is really attractive right now, particularly relative to the rest of the fixed income market.

Jay Diamond: Karthik, as you said before, structured credit is not a monolithic single sector. It is a technology and there are many different asset classes that are represented within structured credit. Take us on a tour, if you will, of current market conditions across the different food groups, as you call it.

Karthik Narayanan: So just to recap, there are four primary areas, and we'll just quickly go through each of them. So, starting off with residential mortgage-backed securities or RMBS. So as a recap, we saw RMBS valuations detach and dislocate from their historical relationship since the COVID period. And it's really only in the last few months that they're starting to normalize. On the fundamental side with mortgage rates as high as they are and housing activity is quiet as it is, the supply of mortgages is very low, with a relatively stable outlook for the labor market, and mortgage loans for the most part, with a few exceptions, having been prudently and conservatively underwritten for over a decade now. This is a part of the market that fundamentally we do not expect there to be a lot of sensitivity to the business cycle. So, whether we end up with a mild recession, as our macro team is calling for, and if it ends up not being a soft landing, or it ends up being a harder landing or an even softer landing, mortgage credit performance is not going to be very heavily affected. So, from a fundamental standpoint, it's kind of an all-weather asset class at the moment. So that's one thing that it has going for it. On the technical side, the knock-on effect of low housing activity and low refinancing activity is that there's not a lot of mortgages being produced. And so, when there's low supply in the market, investors have fewer things to choose from. That tends to be somewhat supportive for pricing. So, both fundamentally and technically, mortgages are in a reasonably good place. Now, although we're expecting low issuance for RMBS, we are still seeing enough of a healthy issuance and a wider variety of collateral types coming to market, and I think this is one theme that we'll be seeing more of in the next 1 to 2 years. We're expecting to see more second lien and home equity line of credit-backed deals, and these are something that we haven't seen for a long time. And just with the sheer amount of home equity baked into the U.S. housing stock, it's roughly half the value of the housing stock, as it is the homeowner's equity. It's not surprising that we're finally starting to see a small amount of issuance there. So, there's a pretty diverse base of collateral types coming to the market. Now in terms of valuation, non-agency mortgages with these, the non-government backed mortgages is one of our favorite areas. We see valuations in the AAA-rated first priority, senior part of the market around the 6 percent yield. Moving away from RMBS to asset-backed securities or ABS. Now just as a reminder for listeners, there's really two flavors of ABS. There's the consumer ABS market, and those are backed by, say, auto loans or unsecured personal loans where there's an individual consumer who is the payer on that contract. And then there is the smaller let's say it's about a third of the overall ABS market, a smaller part called the commercial ABS market, and this is the part of the market where the underlying assets are generated in the context of commercial activities between businesses. So, examples there, as we've spoke about, are shipping containers, franchise royalty streams, long-term contracts from household name tech companies to data centers. So those all fall into the category of can commercial ABS. Now, commercial ABS has had very low issuance because many issuers came to the market in the 2020 and 2021 timeframe when interest rates were very low, which coincidentally is very similar to what we've seen in the high-yield market, where a lot of issuers were opportunistically issuing debt in the 2020-2021 timeframe. And what that means for the ABS market is that there's not a lot of maturities coming up, and so because of that, the issuance has been quite low. There's not a lot of credit demand to go out and finance M&A activity or new deals, and this low level of activity has, to dovetail to Danny's point, created a lag between ABS performance and the more liquid credit investment grade sector that really started rallying in November of last year. And we didn't see that really start to happen in ABS until the beginning of this year and actually more into late January. So, ABS valuations when we get to certain subsectors of the commercial ABS market, which are generally BBB or A-rated, we see those yields in the high 5s to mid 6s, depending on the specific asset classes and a very low technical, very low supply picture helps the technical argument there. So, commercial ABS is one of the sectors we are more favorably disposed to at this moment as well. Moving on to the third part of the structured credit market, CLOs. This has been a really interesting story. The CLO technical and fundamental picture is not as favorable as it is for RMBS and ABS, but we still think that there's interesting investments to make in the sector. Issuance in the CLO market is down year over year, but in the big picture, this market has been quite resilient considering the headwinds that are emerging in the underlying credit markets. We're in the early days of a credit cycle and it's no secret that the capital structures of many of these companies in leveraged loan market are experiencing stress due to higher interest rates and other sort of industry specific factors, if you think about certain places like tech or health care. But the good news for CLO is that there's structure to absorb these credit losses and certainly much higher losses than what we expect to see in the cycle, especially when you get to the senior part of the CLO investable capital structure. So, say AAA, AA or A rated CLOs, which could withstand defaults of Great Depression type levels and still return principal. These bonds are trading in the 7 to 8 half percent area under a wide range of underlying loan default recovery scenarios. So, we also view this as a pretty good all-weather trade, but we do acknowledge that the technical picture for CLOs in terms of issuance is not high, but it's not as low as what we see in the ABS or RMBS markets is neutral, and the fundamental picture is somewhat challenged. So, we are being defensive there, but we think this is a good place for income potential, perhaps not as much from a total return potential, but should be a stable income is the thesis we're going for it here. The other bit I'll mention about CLOs and an interesting point to note for listeners that may not sort of make it in the mainstream discussion is the emerging issuance of CLOs backed by middle market or private credit secured loans. So, this is a part of the market that's been around for a long time. We certainly followed it from the late nineties, but the middle market CLOs, or lower private credit CLO market is historically issued $10 to $15 billion a year. That was sort of the number before COVID. It'll probably be between $30 to $40 billion this year, so much higher, and reflecting the growth in that underlying market. It's a different animal than the traditional broadly syndicated CLO. It's much more reliant on the platform of the underlying lender and the industries and capital structures that they tend to traffic in, but there are material structural benefits in these deals in the form of much higher credit enhancement. And there's also pricing and valuation benefits. As you know, even at the AAA level, the private credit or middle market CLO trade at a .75 percent wider yield than broadly syndicated, sort of mainstream CLOs. So, some of the niche parts of that market are seeing some increased activity, and that's something we're keeping tabs on. And Jay, just to round things out, finally with commercial mortgage-backed securities, this is a sector that on its surface you'd think the technical should be favorable because they're not making a lot of these. The issuance is way down because commercial real estate transactions are way down, but really the fundamentals far outweigh that our own mind. So, we're very cautious on commercial real estate in general and CMBS specifically. We think commercial real estate is undergoing a very slow-moving repricing and shake out of credit availability and we have some ideas of how this is going to play out, but in all of those scenarios, the passage of time is a common denominator. So, in CMBS, we're being very selective in investing in deals that have a high degree of credit support and underlying properties that have good visibility. So, an example of that is the niche market of commercial real estate backed CLOs, which is a subsector of the CMBS market that's primarily backed by multifamily properties. Certainly, multifamily properties are having some issues on the expense side as well as in financing costs, but there's many of these properties that are doing fine, and these deals were structured with a lot of credit enhancement and at the senior level where they can withstand a very wide range of outcomes. Yields on these deals are in the high 6 to 8 percent at the AAA to A level. So, this is a very small part of the market, it's a very defensive play, and we believe that there's a good liquidity premium. It’s small part of the market with finite availability, but we believe that there's a good complexity premium that that we can earn while still being defensive on an asset class that we want to be defensive on.

Jay Diamond: Now, Danny, Karthik just gave us a roundup of what he's seen within the structure credit sector, but what are you seeing across the range of fixed income sectors that you're looking at as a portfolio manager? How is your team thinking about portfolio allocations and weightings right now and going forward?

Danny Gibbs: So, there's always two elements we have to wrestle with to really answer that question, starting with our general top down macro level biases, which though maybe it's moderated over the last couple of months, just with the degree of the easing that we've seen in financial conditions. Our broader market view still leans defensive as Karthik said. We've obviously seen a string of strong economic prints, but there's a good degree of dispersion in terms of strength underneath the hood. Smaller companies, less affluent consumers, each have seemingly been more directly and disproportionately hit by the Federal Reserve's fight against inflation. And now both of those groups face maturity walls and savings exhaustion. Aside from that, we've seen default rates continue to move higher in high-yield and loans and then similarly, recovery rates on those actual defaulted issuers coming in at lower rates than we've seen compared to historical averages. So, in short, I would say we're still pretty skeptical to the actual soft landing narrative that we would say the Fed's runway for potentially achieving it is may be extended a bit. The second consideration when thinking about the evaluating the fixed income landscape is really valuations or where bonds are trading at or where they're sourceable. So, putting those two together, it's really trying to marry what are the actual risks that we're perceiving in the market and do we feel each of these asset classes are adequately pricing in those risks. I guess to continue on that thought, we can be incredibly bearish on the economy as a firm but feel credit spreads in lower credit quality sectors like high yield corporates or bank loans are sufficiently compensating investors per risk, in which case we'd be more biased at exposure there. Conversely, we could be optimistic about the trajectory of the broader economy but feel those same lower credit quality asset classes are too priced for perfection, leaving your risk/reward distribution more negatively skewed. What's convenient about the current environment is that the valuation picture actually meshes pretty nicely with our top-down views and that our macro views call for a more defensive positioning or a higher allocation to higher credit quality parts of fixed income, but then looking at the valuation picture, those same securities, higher credit quality asset classes like structured credit, particularly senior tranches and structured credit agency RMBS. These sectors all look cheap to their historical trading ranges, whereas on the other side of the credit spectrum, things like bank loans, high-yield corporates, even parts of the investment grade corporate market are looking pretty rich relative to their historical trading ranges. So, it's one of these kind of perfect environments where our macro level thinking and the actual valuations presented to us fit together nicely, and we're being paid to be defensive in our portfolios.

Jay Diamond: What is the firm's overall appetite for credit or duration or liquidity risk?

Danny Gibbs: I would say it's still defensive at the moment. There's always nuance to that. There are higher credit quality issuers within the high yield market that we like. Similarly, there are parts of the Agency RMBS market that we think are screening too rich, but if I were to give a very high-level answer to that, it's leaning more towards higher credit quality asset classes and issuers within each respective asset class.

Jay Diamond: Okay. Well, listen, Danny and Karthik, you guys have been very generous with your time during a busy week, but before we let you go, Danny, what would be the main takeaway for our listeners from today's conversation?

Danny Gibbs: You're being paid in this market to be defensive, and if you look at where yields are on a historical basis, they're still near historical highs. Credit spreads are more attractive in some asset classes versus others, but I think are adequately pricing in the risks in the current market. So, it's a good time to be invested in fixed income.

Jay Diamond: Thank you. And Karthik, any final thoughts for our listeners today?

Karthik Narayanan: Thanks, Jay. Well, first of all, thank you for hosting us here again. And I'd like to, of course, thank all of our listeners for giving us the opportunity and airtime to talk about structured credit, and portfolio management, and the business, and how we do things. So, thank you all for your continued support and listening to what we're talking about.

Jay Diamond: Well, great. Again, thank you very much for your time, Karthik and Danny. I hope you'll come again and visit with us soon. And thanks to all of you who have joined us for our podcast today. If you like what you are hearing, please rate of five stars. And again, if you have any questions for Karthik or Danny or any of our other podcast guests, please send them macromarkets@guggenheiminvestments.com and we will do our best to answer them on a future episode or offline. I'm Jay Diamond and we look forward to gather again for the next episode of Macro Markets with Guggenheim Investments. In the meantime, for more of our thought leadership, visit guggenheiminvestments.com/perspectives. So long!

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Stock markets can be volatile. Investments in securities of small and medium capitalization companies may involve greater risk of loss and more abrupt fluctuations in market price than investments in larger companies. The market value of fixed income securities will change in response to interest rate changes and market conditions among other things. Investments in fixed-income instruments are subject to the possibility that interest rates could rise, causing their value to decline. High yield securities present more liquidity and credit risk than investment grade bonds and may be subject to greater volatility.

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