Taking the Temperature of the Structured Market

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The national response to the Covid-19 pandemic has created unparalleled disruption to the global economy with ramifications for financial markets including structured finance. While policymakers have responded to this disruption with unprecedented monetary and fiscal countermeasures, including unlimited quantitative easing and the $2 trillion CARES Act, uncertainty around the epidemic's length and effectiveness of the policy response will overhang structured securities' performance.

The deterioration in economic activity associated with the Covid-19 response will be experienced differently across structured finance sectors and industries. Pandemic-related business closings will adversely effect both commercial borrowers through lost revenue, as well as consumer obligors via lost jobs, restricted employment and fewer working hours. This impact will likely contribute to a sharp near-to-intermediate term increase in deferrals and delinquencies across most securitized sectors.

A healthy backdrop to aid recovery

Structured finance sectors were broadly healthy pre-Covid-19. Collateral credit performance was reflective of prevailing economic conditions with consumer and commercial obligor delinquency rates near cycle lows. Commercial real estate credit performance was strong with property valuations and cash flows supporting low leverage and ample debt service coverage. Similarly, housing fundamentals were buoyed by steady home price appreciation and low mortgage rates. With limited exceptions, securitization structures today generally exhibit lower leverage, higher debt service capacity and increased credit enhancement compared to pre-2008 global financial crisis (GFC) levels. These added protections at each rating level were designed specifically to protect investors from a sudden adverse performance shock and redefine acceptable volatility within a rating category. Rating agencies, regulators and market participants have all learned from past experiences and incorporated these learnings into their processes.

Pandemic impacts across securitized sectors

Across nearly all sectors, the length and severity of the pandemic will play a key role in how rating agencies determine the credit implications to securitization structures. Assuming the severity and length of decline does not exceed prior downturns, low and medium-impacted sectors are unlikely to experience performance deterioration that would result in downgrades to below investment grade, especially for the highest rated tranches. Securities in the highest impacted sectors could experience more severe adverse ratings volatility if they are not otherwise enhanced or specifically supported by government programs. Performance declines of the highest impacted sectors have the potential to mirror specific historical stress events if not for certain stimulus activities. Depending on the sector, securitization performance will be affected by higher delinquencies, lower payment rates and a deteriorating credit outlook. This could be offset by the effectiveness and speed of policy responses such as unemployment insurance, forbearance measures and alternative lending programs.

Exhibit 1: Securitized industries at risk

The following table details early assessments of the pandemic's effect on securitized industries, categorized by high, medium and low risk.


Collateralized loan obligations: Limited downgrade actions have occurred; however, several negative watch notices for deeply subordinated tranches have been announced as a result of increased ratings migrations among loan issuers. Loan issuer rating downgrades have increased CLO exposure to CCC-rated credits that, when combined with lower loan prices, will likely result in redirected cash flow to accelerate the pay down of senior tranches. As such, these downgrades could benefit senior bonds over mezzanine and subordinate tranches. Further underlying loan downgrades, defaults or restructurings, and the pace of cash flow redirection to amortize down the senior tranches, will be the key factors in determining rating migrations for senior CLO tranches. Senior ("AAA/AA") CLO holdings are structured with robust enhancements and should maintain investment grade credit ratings.

Commercial mortgage-backed securities: Lodging and retail loans will be challenged by lower cash flows available to support debt service. Lodging will face the most significant near-term challenges as cancelations, closures and travel restrictions have a significant negative impact on current cash flow. Discretionary retail tenants will also come under financial pressure due to closings and decreased sales volumes; landlords may be required to provide rent relief. It is expected that stronger borrowers will likely support the transactions to the minimum degree required until business activity returns. Rating agencies have already placed broad portions of the lodging and retail universe on watch with further ratings action contingent on the depth and duration of the crisis. We expect, even in one of the most impacted sectors, senior CMBS holdings ("AAA/AA") to maintain their investment grade ratings.

Residential mortgage-backed securities: Drawing on lessons learned during the GFC and recent natural disasters, delinquencies will likely be addressed through temporary payment relief efforts designed to alleviate borrower strain. The recently enacted CARES Act grants borrowers in federal government-sponsored mortgage programs payment forbearance for up to 12 months. The CARES Act provisions do not apply to private-label mortgages and likewise, private label securitization servicers have not announced similar programs. We anticipate legacy RMBS (issued pre-GFC) will experience incremental valuation, capital and accounting stress from rising delinquencies given much of their credit enhancement was depleted by GFC-related losses. RMBS issued post-GFC will likely also experience elevated delinquencies; however, post-GFC holdings were securitized with significant credit enhancement that should provide adequate protection against credit-related losses. While repayment profiles for these holdings are expected to lengthen as delinquencies slow repayment rates, we do not expect any post-GFC RMBS to migrate below investment grade given the level of credit support and priority of all principal cash flows.

Asset-backed securities: Sectors that depend directly on consumer repayment such as prime and subprime auto loans, credit cards and timeshare receivables will likely see performance deteriorate in the short term with longer-term ramifications dependent on the slowdown's duration. Delinquencies have the potential to spike significantly in some consumer sectors given recent unemployment claims and disruptions in work; however, provisions within the CARES Act, such as fiscal stimulus and expanded unemployment insurance, should moderate the financial impact on consumer obligors. Commercially-oriented sectors such as dealer floorplan and rental car ABS rely more heavily on the sponsor's liquidity profile, corporate credit strength and vehicle sales activity and will vary according to their pre-virus resources and implementation of mitigation activities. Esoteric sectors such as triple net lease and whole business ABS, focused on casual dining restaurants, quick service restaurants, movie theatres and home furnishing stores, have been substantially impacted by the economic slowdown. Support from the small business rescue provisions within the CARES Act could assist companies in these sectors in making payroll and lease obligations and help offset disruption, but these issues will be harder to solve and will take more time to sort out under the best conditions.

Senior consumer and commercial ABS structures are best suited to help protect investors against sudden shocks in credit performance. Aiding these transactions is a of combination structural features such as overcollateralization, excess spread and reserves that help mitigate performance deterioration and provide more ratings stability However, given the unprecedented shut down of businesses across the United States and early indications that unemployment levels will elevate significantly, businesses and consumers, in even time-tested platforms, will, at a minimum, be temporarily challenged. Ratings migration will occur in the near term in highly impacted sectors (aircraft, container, small business) with rating migrations of less directly impacted sectors dependent on the duration of the slowdown.

Fundamentally stronger than valuations imply

As the impact of Covid-19 containment measures playout, volatility will continue to disrupt the global economy and financial markets. Pandemic-related uncertainty has resulted in severe price volatility across all credit markets, and structured finance is not immune. Historic mutual fund outflows, de-leveraging from mortgage REITs and hedge fund redemptions have created heavy selling pressure, which has exacerbated the dislocation. Across structured finance sectors, spread widening reached levels that have not been seen since the GFC. However, unlike the GFC where spread widening was driven by both credit concerns and a poor liquidity environment, recent volatility has primarily been liquidity driven. We believe against this backdrop, structured finance asset valuations have significantly overshot fundamental concerns, particularly evaluated against the low leverage and structural support commonly found in securitization structures, and are well positioned for recovery as markets normalize.

Structured finance with Aegon Asset Management

The Structured Finance investment team at Aegon AM has navigated multiple credit cycles since the inception of the asset class in the late 1980s. The portfolio managers and research analysts have a repeatable process to evaluate creditworthiness and the relative value of investments in the structured finance universe. The research team covers all structured finance sub-sectors across the quality spectrum and collaborates with the firm's global credit research analysts on the fundamental strength of issuers and leverages real estate professionals from Aegon Real Assets. Aegon AM employs a fundamental, research-driven investment process with a focus on total return. The portfolio management and structured research teams have the ability and experience to understand collateral and complex deal structures, helping the team identify opportunities to oscillate risk at market inflection points.

Disclosures

Past performance is not indicative of future results. The client's return will be reduced by the advisory fees and any other expenses it may incur in the management of its investment advisory account. You cannot invest directly in an index, which also does not take into account trading commissions and costs.

This material is to be used for institutional investors and not for any other purpose. The enclosed information has been developed internally and/or obtained from sources believed to be reliable. This material contains current opinions of the manager and such opinions are subject to change without notice. Aegon AM US is under no obligation, expressed or implied, to update the material contained herein. This material contains general information only on investment matters; it should not be considered a comprehensive statement on any matter and should not be relied upon as such. If there is any conflict between the enclosed information and Aegon AM US' ADV, the Form ADV controls. The information contained does not take into account any investor's investment objectives, particular needs or financial situation. Nothing in this material constitutes investment, legal, accounting or tax advice or a representation that any investment or strategy is suitable or appropriate to you. The value of any investment may fluctuate.

All investments contain risk and may lose value. Structured Finance assets (such as ABS, RMBS, CMBS and CLOs) are complex instruments and may not be suitable for all investors. The assets may be exposed to risks such as interest rate, credit, liquidity, issuer, servicer, underlying collateral, prepayment, extension and default risk. Investors typically receive both interest and principal payments for a security and these prepayments may reduce the interest received and shorten the life of the security. Although some types of structured finance securities may be generally supported by a form of government or private guarantee, there is no assurance that guarantors will meet their obligations. Diversification does not ensure a profit nor guarantee against loss.

Specific sectors mentioned do not represent all sectors in which Aegon AM US seeks investments. It should not be assumed that investments of securities in these sectors were or will be profitable.

Aegon Asset Management US is a US-based SEC registered investment adviser and is also registered as a Commodity Trading Advisor (CTA) with the Commodity Futures Trading Commission (CFTC) and is a member of the National Futures Association (NFA). Aegon Asset Management US is part of Aegon Asset Management, the global investment management brand of the Aegon Group.

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Jim Baskin

About Jim Baskin

Jim Baskin, Head of US Structured Research