Credit Management

Active Credit Management and Structured Financial Instruments

Active credit managers in the financial sector utilize a range of tools, including structured financial instruments, to manage credit risk and enhance returns. These instruments, derived from various sources like commercial or residential real estate, allow managers to access fixed-income cash flows.

For instance, consider an example of a mortgage-backed security (MBS). The MBS increases portfolio exposure to interest rate volatility through mortgage prepayment and extension risk, thereby enhancing returns. It also adds debt exposure by redistributing default risk across different tranches.

In ABS, the issuer is a Special Purpose Vehicle (SPV) that owns the underlying asset pool and issues debt across several tranches. These tranches are backed by the asset pool cash flows, allowing for redistribution of default risk, beneficial for active credit managers.

Redistribution of Default Risk in Asset-Backed Securities (ABS)

This topic delves into the redistribution of default risk from the underlying asset pool, a concept previously discussed. This is achieved by creating higher-rated tranches through internal credit enhancement or overcollateralization, causing lower-rated tranches to bear a larger share of the default risk.

For instance, an investor who anticipates a recovery in the credit cycle might overweight default risk by choosing a lower-rated ABS tranche, expecting these tranches to experience greater spread tightening than higher-rated tranches. Conversely, a portfolio manager might strategically underweight credit exposure by opting for a higher-rated tranche during a downturn to minimize potential losses.

Another investment option is covered bonds, which offer real estate cash flow exposure similar to ABS. These bonds have dual recourse, meaning they can be claimed from both the issuing financial institution and the underlying asset pool. They also involve the substitution of non-performing assets, resulting in lower credit risk and yield. Structured products can be strategically used by investors and portfolio managers to manage credit risk and yield.

Practice Questions

Question 1: Structured financial instruments are a key tool for active managers in the financial sector. They can be used to access fixed-income cash flows, enhance returns, and add debt exposure. One way they enhance returns is by increasing portfolio exposure to interest rate volatility through mortgage prepayment and extension risk. In the case of Asset-Backed Securities (ABS), the issuer is a special purpose vehicle (SPV) that owns the underlying asset pool. How does the SPV use this structure to create ABS?

1. The SPV issues debt across several tranches backed by the asset pool cash flows.
2. The SPV sells the underlying asset pool to investors.
3. The SPV redistributes the default risk to the investors.

Answer: Choice A is correct.

The SPV uses this structure to create ABS by issuing debt across several tranches backed by the asset pool cash flows. In the process of securitization, the SPV purchases a pool of assets, such as loans, leases, or receivables, and then issues securities that are backed by the cash flows from these assets. These securities are divided into several tranches, each with a different level of risk and return. The cash flows from the underlying assets are used to service the debt issued by the SPV. This structure allows the issuer to transform illiquid assets into tradable securities, thereby providing a source of funding and enhancing liquidity. It also allows investors to gain exposure to a diversified pool of assets that they might not otherwise have access to, and to choose a level of risk and return that suits their investment objectives.

Choice B is incorrect. The SPV does not sell the underlying asset pool to investors. Instead, it issues securities that are backed by the cash flows from these assets. The investors do not own the underlying assets, but they have a claim on the cash flows generated by these assets.

Choice C is incorrect. While the SPV does redistribute the risk associated with the underlying assets to the investors, this is not the primary way in which it uses the structure to create ABS. The main purpose of the structure is to issue debt that is backed by the cash flows from the underlying assets, not to redistribute default risk. Furthermore, the risk redistribution is achieved through the tranching of the securities, not through the SPV structure itself.

Question 2: Active managers in the financial sector use structured financial instruments to access fixed-income cash flows and enhance returns. These instruments can also be used to add debt exposure by redistributing default risk into different tranches across the credit spectrum. In the context of Asset-Backed Securities (ABS), the issuer is a special purpose vehicle (SPV) that owns the underlying asset pool. What is the primary source of cash flows for these structured financial instruments?

1. The cash flows are primarily derived from commercial or residential real estate.
2. The cash flows are primarily derived from the SPV’s operating income.
3. The cash flows are primarily derived from the sale of the underlying asset pool.

Answer: Choice A is correct.

The primary source of cash flows for these structured financial instruments, such as Asset-Backed Securities (ABS), is primarily derived from commercial or residential real estate. In the context of ABS, the underlying assets are often a pool of loans, such as mortgages, auto loans, or credit card receivables. The cash flows from these loans, which include both principal and interest payments, are used to service the ABS. The SPV, which is the issuer of the ABS, owns these underlying assets and passes the cash flows from the assets to the investors in the ABS. The cash flows from the underlying assets are the primary source of returns for the investors in the ABS. This structure allows the risk of the underlying assets to be separated from the risk of the issuer, providing a degree of protection for the investors.

Choice B is incorrect. The cash flows are not primarily derived from the SPV’s operating income. The SPV is a legal entity created solely for the purpose of issuing the ABS and owning the underlying assets. It does not have any other operations that would generate operating income.

Choice C is incorrect. The cash flows are not primarily derived from the sale of the underlying asset pool. While the underlying assets may be sold if the borrowers default on their loans, this is not the primary source of cash flows for the ABS. The primary source of cash flows is the regular principal and interest payments from the borrowers of the underlying loans.

Glossary

• Structured Financial Instruments: Financial tools that allow for the redistribution of risk and access to fixed-income cash flows.
• Asset-Backed Securities (ABS): Debt securities backed by an asset pool, issued by a Special Purpose Vehicle (SPV).
• Special Purpose Vehicle (SPV): A subsidiary created by a company to isolate financial risk.
• Overcollateralization: A type of credit enhancement where the collateral’s value exceeds the loan’s value.
• Internal Credit Enhancement: A method of reducing the risk of default by structuring the priority of repayments.

Portfolio Management Pathway Volume 2: Learning Module 6: Fixed-Income Active Management: Credit Strategies.

LOS 6(i): Describe the use of structured financial instruments as an alternative to corporate bonds in credit portfolios