By Sam Diedrich , associate director and fixed income relative value portfolio manager, PAAMCO
Structured credit, the centerpiece of the global financial crisis of 2008, has recently regained momentum. As the market has marched toward recovery, structured credit has once again provided high risk-adjusted returns.
There have been, however, clear differences in the rate of recovery between the US structured credit market and the market in Europe. US structured credit has been one of the primary beneficiaries of the recent scramble for yield, but in the European market the recovery is far from finished. The dislocations within the European structured credit market currently offer attractive yield potential, but at the cost of lower liquidity and with the looming issue of the sovereign crisis in the eurozone. Meanwhile, the US structured market, despite recent rallies, remains attractive on a number of valuation metrics across many sectors including non-agency residential mortgage-backed securities (RMBS). Though the underlying bonds have similarities in design, collateral type, and performance drivers, there are some fundamental structural differences between the US and European markets. The first and most obvious difference is size: the US market ($10.4trn) is roughly five times the size of the European market ($2.3trn). A key factor contributing to this differential is the absence in Europe of government-sponsored agencies that issue and guarantee asset-backed securities, such as Freddie Mac and Fannie Mae in the US. In Europe, banks are the largest originators of European structured products. Given recent moves by European banks to deleverage, new issuance of structured products in Europe has been anaemic. Further, banks and insurance companies constitute the bulk of the investor base for structured products in Europe, as opposed to the US market where banks represent less than a quarter of a much broader constituency of investors. European regulatory changes following the financial crisis have severely impacted the ability of banks and insurance companies to invest in structured credit products, which has led to a reduction in demand in European markets. The European structured credit market is also much more segmented compared to the highly standardised US market. The European structured credit market is essentially a mosaic of varying legal/regulatory environments, and usually different asset classes dominate in different jurisdictions (e.g. RMBS in the UK and Netherlands and leases in Italy). Coordination among issuers across regions tends to be quite limited in Europe, which has led to a lack of standardisation, transparency and liquidity. Investors in general have found it relatively burdensome to manage documentation and, therefore, tend to rely more on external ratings. Beyond differences in market structure between the US and Europe, there are also key differences in the underlying risks and performance characteristics of the collateral pools. Most European jurisdictions allow recourse to assets in the case of default for residential mortgage loans, resulting in a default rate in Europe that is much more reliant on the unemployment rate than changes in housing prices. The lending criteria in Europe are generally higher as well, with lenders requiring better credit and larger down payments. This tends to result in comparatively better performance in the underlying collateral pools of European RMBS. In the US, in contrast, residential mortgage collateral performance has generally been extremely poor within 2006 to 2008 vintages, with default rates often upwards of 60% or more. Meanwhile, in commercial mortgages and corporate-backed structured products, European collateral performance has generally been a bit weaker than in the US, as they have been affected by the weaker economic conditions in Europe. In summary, investors can still buy US distressed bonds high in the capital structure for low to mid-single digit returns in a market that is showing signs of improving fundamentals. In Europe, investors can reap similar returns but must generally go lower in the capital structure for relatively less liquid bonds.
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