Key Takeaways

• Structured credit historically has offered investors the potential for attractive risk-adjusted returns, diversification benefits and bespoke credit-risk exposure over multiple cycles. The assets may be particularly appealing currently in light of today's high base interest rates and the attractive spreads offered by certain product types.
• Despite lower credit default rates, structured credit historically has offered higher yields than similarly rated traditional fixed income products. Fundamental investors able to differentiate between an instrument's rating and its actual credit risk, in our view, may take advantage of agency mis-ratings to seek incremental income.
• In our experience, the ability to analyze, value and actively manage structured credit assets is key to accessing the durable incremental returns offered by this asset class. First Eagle's Napier Park unit has a team of professionals who have been actively managing structured credit risk and investment for over 30 years.

Structured credit typically refers to the process by which groups of similar, income-generating assets are pooled together into marketable fixed income securities. The assets comprising these pools may include traditional debt instruments (like residential mortgages and corporate loans), more esoteric cash streams (like airplane leases and music licensing revenues) or derivatives contracts (like swaps and options).

From a macroeconomic perspective, the securitization process effectively transfers the risk of a large amount of mostly illiquid debt from the original provider of capital—typically, banks or specialty finance companies—to investors, providing the seller with term, non-recourse financing while also increasing the supply of credit in the system and promoting broader price discovery. For investors, structured credit offers the potential for higher returns, portfolio diversification and tailored credit-risk exposure.

While certain risks typical of structured credit—such as complexity, illiquidity and volatility—suggest a yield premium over traditional credit investments is warranted, we believe other factors also may play a role. Perhaps most notable among these is what we view as a persistent disconnect between the ratings assigned to the structured products and their realized default rate. By consistently applying more punitive criteria to the evaluation of structured credit investments compared to traditional corporate or consumer debt, rating agencies historically have created durable opportunities for investors experienced in the asset class to harvest meaningful incremental yield with manageable incremental risk. Given the attractive risk-adjusted returns structured credit has generated over time, we believe the asset class may represent a compelling strategic allocation for many long-term portfolios, as appropriate.

A Large and Diverse Asset Class

Structured credit instruments most commonly start with the bundling of income-producing credit assets and subsequent issuance of multiple debt securities collateralized by their cash flows. Also gaining popularity in recent decades have been synthetic structures in which a basket of derivative contracts (like credit default swaps, or CDS) are grouped together and issued as an exchange-traded security (the credit default swap index, or CDX). Claims on these cash flows or derivative payments are divided into tranches that stratify credit risk based on seniority, providing investors the opportunity to target a range of risk/return profiles. Investors higher in the capital structure have a priority claim on the asset pool's cash flows and receive a relatively lower yield as a result, while those further down in the structure are most susceptible to impairments and defaults but also receive greater compensation for these risks. In addition to multiple debt tranches, securitizations typically include a first-loss equity tranche—often owned in part by the originator to promote an alignment of interests—that has a claim on all residual cash flows once interest and principal is paid in full to debtholders.

The market for structured credit is vast and varied. As of June 2024, structured credit outstanding in the US alone amounted to over $14 trillion across a range of instruments and backed by a variety of collateral; this represents about 25% of all debt outstanding in the US, second only to Treasuries.¹ Highlighted in shades of blue in Exhibit 1, the nearly $3.3 trillion of securitized debt outstanding in the non-agency-guaranteed structured credit market is divided between securities backed by loans on real estate (both residential and commercial) and those backed by other forms of consumer and corporate credit. Collateralized loan obligations (CLOs), which are backed by pools of broadly syndicated corporate loans, and asset-backed securities (ABS), backed by consumer debt such as student loans and credit card balances, are the most prominent forms of the latter category. But more esoteric products also are available, with cash flows backed by everything from aircraft and shipping containers leases to music royalties (aka “Bowie Bonds” in honor of the first musician to participate in such a securitization).

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