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9 May 2024

This article aims to provide you with a general understanding about Securitised Credit. While Securitised Credit may be a beneficial addition to your portfolio under certain circumstances, you should not rely solely upon this article to make investment decisions.

What is Securitised Credit?

Securitised Credit is an asset class which consists of bonds or instruments that comprise cash-generating assets such as residential and commercial mortgage loans, auto loans, credit card loans, etc. These illiquid assets are purchased and restructured into various tranches through the securitisation process.

The differences between Securitised Credit and bonds

Set Title
	Bond	High yield bond	Securitised credit
Coupon rate	Fixed rate generally	Fixed rate generally	Floating rate in general, offers a margin above a reference rate
Cash flow to pay coupons	Generated from issuer’s underlying business activity	Generated from issuer’s underlying business activity	Generated from underlying collateral (e.g., the repayments on mortgages)
Maturity	Fixed usually, with all the principal received on the maturity date	Fixed usually. with all the principal received on the maturity date	Depends on collateral characteristics e.g., principal prepayment, default rates and structural features
Tranche	All holders of the bond receive payments and suffer losses equally	All holders of the bond receive payments and suffer losses equally	Note holders receive payments and suffer losses depending on how senior their note is
Credit rating	Depends on the ability of the issuer to repay the bond	Depends on the ability of the issuer to repay the bond. Non-investment grade bonds are rated below BBB-	Depends on the tranche’s probability of suffering losses subject to the underlying collateral and structure of the securities

_{Source: HSBC Asset Management, June 2022. For illustrative purpose only, with all other factors assumed to be equal.}

How does it work?

A group of assets is purchased and transformed into Securitised Credit by a Special Purpose Vehicle (SPV) which is a separate company of a financial institution with its own balance sheet. It bears the obligations and liabilities of such loans and gets financing by grouping these loans into different tranches based on their characteristics such as maturity, credit ratings, etc. Senior tranches typically have higher credit ratings due to their payment priority.

Five reasons to consider Securitised Credit

Yield pick-up: Securitised Credit can offer a yield premium compared to traditional bond instruments.
Floating rate exposure: Securitised Credit, which is largely a floating rate, offers a spread above a short-term reference interest rate. The yield usually follows the moves in interest rates. Whilst interest rates are anticipated to fall in 2024, they are likely to remain higher than the past decade, meaning yields on offer are still attractive.
Room for price appreciation: Being a credit product, as interest rates fall, Securitised Credit spreads are likely to tighten. Furthermore, their spreads have remained artificially wide since COVID and have yet to really tighten in comparison to traditional fixed income, providing room for price appreciation.
Credit enhancement: provides a cushion against collateral losses via features such as tighter covenants, overcollateralisation¹, etc.
Diversification benefits: it has low correlation to other bonds and can increase portfolio diversification within the bond allocation.

Types of Securitised Credit

Key risks

Interest Rate Risk: As interest rates rise debt securities will fall in value. The value of debt is inversely proportional to interest rate movements.
Credit Risk: Issuers of debt securities may fail to meet their regular interest and/or capital repayment obligation. All credit instruments therefore have the potential for default. Higher yielding securities are more likely to default.
Asset Backed Securities (ABS) Risk: ABS are typically constructed from pools of assets (e.g. mortgages) that individually have an option for early settlement or extension, and have potential for default. Cash flow terms of the ABS may change and significantly impact both the value and liquidity of the contract.
Derivative Risk: The value of derivative contracts is dependent upon the performance of an underlying asset. A small movement in the value of the underlying can cause a large movement in the value of the derivative. Unlike exchange traded derivatives, over-the-counter (OTC) derivatives have credit risk associated with the counterparty or institution facilitating the trade.
High Yield Risk: Higher yielding debt securities characteristically bear greater credit risk than investment grade and/or government securities.
Liquidity Risk: Liquidity is a measure of how easily an investment can be converted to cash without a loss of capital and/or income in the process. The value of assets may be significantly impacted by liquidity risk during adverse markets conditions.
Operational Risk: The main risks are related to systems and process failures. Investment processes are overseen by independent risk functions which are subject to independent audit and supervised by regulators.

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Notes

1. Overcollateralisation: The face value of the underlying loan pool is greater than the par value of the issue bonds. Even if some of the underlying loans are defaulted, the interest or principal on the bonds will still be paid.

[Start Investing] Why Securitised Credit?