Lending lowdown Podcast

Structured Credit Outlook

Episode 19, Season 1

Noelle Sisco, Managing Director and Portfolio Strategist at Napier Park joins CJ Doherty to discuss the outlook for the structured credit market as we head into 2024. “The big question mark for the U.S. consumer will be the trajectory of unemployment,” said Sisco. “Going forward into 2024, on the corporate side, we expect to see a continuation of elevated defaults with lower than historical recovery levels as we saw in 2023.”

Host: CJ Doherty

  • CJ Doherty: Welcome to the Lending Lowdown. I'm CJ Doherty, director of analysis at LSEG LPC. And today, we're going to change it up a bit from recent topics and focus on the broader structured credit market, which is something we've not covered to date in what is our 19th podcast in the series. The broader structured credit fixed income market in its various forms is roughly 12 trillion in size. For those not familiar with it, so it's a very substantial market and has a large impact on the wider economy. And so to discuss this market, I'm delighted to be joined by Noelle Sisco, managing director and portfolio strategist at Napier Park. It's great to have you on. Thanks for joining me.

    Noelle Sisco: I'm very happy to be here. Thank you, CJ.

    CJ Doherty: OK. So Noelle, can you share some information about Napier Park and your background and current role before we dive into the Q&A?

    Noelle Sisco: Certainly. So I'm a portfolio strategist at Napier Park. I work on the investment team with our CIO risk management group and our senior PMs to implement and drive portfolio strategy across the credit fund business. I've been in asset management for the entirety of my career and joined Napier Park in 2016. Napier Park is a $20 billion alternative asset management firm focused on investment opportunities and specialized and alternative credit. The firm's senior management team has worked together for just over 2 decades. The firm was acquired by First Eagle Investments in 22. We continue to operate as an independent firm and the acquisition has provided us with a broadened sales distribution and access to more diversified investor base. While widening First Eagle’s product suite as a firm, we have 3 core business areas. We have credit funds covering US and European markets, a global CLO platform and a real asset investment business. For today's discussion, I'm just broadly I'll plan to focus my responses with respect to our credit fund business.

    CJ Doherty: OK, great. So to start the Q&A, you know, for our listeners, can you help define alternative credit?

    Noelle Sisco: Alright, absolutely.

    Noelle Sisco: So alternative credit, specialized credit alternative fixed income, there are a few different ways to bucket this space, but overall it's not very well defined. For us we consider alternative credit generally to be non investment grade. You'll generating assets with some degree of structural complexity. Uh, these generally take the form of complex public credit. Sorry, complex public credit and specialty private credit investments on the public side. Our universe consists of US and European corporate exposures through collateralized loan obligations or CLOs. Credit derivatives such as CDX tranches and stress single name credits, as well as exposure to the US consumer through consumer and mortgage backed securities like auto ABS or agency credit risk transfer securitizations in the residential space. On the private side, this may take the form of steel warehouses, residential and consumer lending, working capital financing, equipment financing and other specialty financing. So a very broad based space. It's fairly oftentimes can be misunderstood, but it's a fairly large and substantial space and we find this to be the focus of our strategy and our business funds.

    CJ Doherty: Yeah, very broad indeed. And So what sort of risk premium can you extract through structured credit?

    Noelle Sisco: Ah, well, first. I must be very clear that past performance is no guarantee of future results and therefore actual results may vary. We've done quite a bit of work on the subject and overall structured credit assets that we traverse in have historically exhibited a spread and yield premium versus single similarly rated single names with lower historical incidence of fundamental impairment, albeit with reduced liquidity and higher price volatility. I think it'd be very helpful to provide a direct example looking at CLO Double B's versus double B leverage loans using index data. Since 2012, the average spread team premium for CLOs to loans is just over 400 basis points. With the current differential at a little over 500 basis points in the favor of CLOs, we think that the current level of premium provides a meaningful cushion versus corporate and is currently at the wider end of the historical range. In terms of fundamental performance differences, there's been quite a bit of research around. They generally limited historical incidents of default for CLO tranches, with recent data indicating that the cumulative impairment rate on global CLO double B over the past 12 years has been roughly 14% of similarly rated corporates. Historical default instance of course is not a sole driver of investment decisions, nor should it be, and substantial fundamental analysis is always required to review and understand the risks associated with these assets. However, based on historical data from our perspective, from a fundamental risk to spread and yield return basis, we think that this is an appealing profile.

    CJ Doherty: OK, great. And so how does Napier Park transact in the alternative credit space?

    Noelle Sisco: Of course, again. I spent quite a bit of time on this given my role on the investment team, how we transact, we apply a combined top down and bottoms up fundamental underwriting approach to the alternative credit universe. From here we seek to achieve 3 core goals for our investors. One is a source yield through across areas that we consider as having an appealing risk and return profile based on our top found market views, 2, we seek to realize that yield through an intensive fundamental credit underwriting process. And three, we seek to generate return exceeding that yield through dynamic portfolio management and asset rotation. Umm, so very actively managed portfolios. We seek to execute these goals through two investment formats, the first of which would be strategies intended to invest following market dislocations to capitalize on price volatility in public assets. And two, through best ideas, vehicles that are invested through cycles with a combined allocation to public and private assets over time.

    CJ Doherty: And what are your views on both opportunities and risks in the structured credit space?

    Noelle Sisco: Um well. Frankly, there's still quite a bit of I'll talk about this just in the context of where we are going into 2024 and and there's quite a bit of uncertainty going into into 2024. We went into 2023, with many researchers indicating recession for the year, which ultimately as we know did not quite play out due to the strength in the US consumer. Going into next year many of the reasons for those recession calls are still very much present. Tighter lending standards elevated rates and risks to growth among others, and going forward, the general range of expectations is is fairly wide. This is not by any means surprising though, as the real economic impact of 500 plus basis points and rate rises can be quite lagged and is likely to continue affecting markets into next year. We do not have a specific view on recession from our side, rather our focal point is what are the risks to our assets and what is currently being priced in from a return perspective versus our views on expected outcomes. To that effect on the consumer mortgage side, the US consumer has started to see some deterioration in quality. We're seeing a rise in debt service coverage ratios. I, you know, gradual drawdown in excess savings that had been built up post pandemic and a gradual uptick in delinquencies. But these are from historically sound levels and a general position of strength. So the consumer starting at a very good place, but we are starting to see some some weakness and deterioration in quality. The big question mark for the US consumer will be the trajectory of unemployment in two 2024 and similarly on the corporate side, I'll talk about US corporates here. Those have seen deteriorating fundamentals as well, but again from a very strong starting point, we're seeing declining interest coverage ratios, declining cash flow coverage. We're seeing increased pressure on margins and cash levels have generally trended downwards across the corporate space. And going forward into 2024 on the corporate side, we expect to see a continuation of elevated defaults with lower than historical recovery levels as we saw in 2023. In terms of how these view shape our positioning, we find that those areas have exposures across the alternative credit landscape that provides substantial yield compensation for the referenced risk factors across assets with structural protections to be the most appealing into 2024.

    CJ Doherty: And and now I'd like to switch gears a little bit. What are the risks, challenges or opportunities, you know that the CLO market faces as we look ahead to next year, what's your outlook there?

    Noelle Sisco: So in terms of the CLO market as as I noted previously with the example of CLO double B's versus leverage loans, there are segments of the CLO market that well compensate investors for the reference risk factors. However, going into 2024, there are portfolios that have certain tails, and so there's certainly is some tail risks across the space. So that's why the you know, the approach to really deeply, fundamentally underwrite these assets, understand the different managers,  manager, tiering manager quality all of those will be absolutely critical. But from a pure yield perspective, CLO  yields are still generally at their higher end of historical range. So assuming investors or assuming you can get comfortable with the reference underlying risk and do the proper fundamental credit underwrite, they're still very attractive return premiums there, which provides a good opportunity into 24.

    CJ Doherty: OK, great. And we briefly discussed near Napier Park’s real assets strategy, you know, and with questions around ongoing inflation. And an increased interest in infrastructure investing as of late. Could you help our listeners understand what sort of risk return profile this sector can provide?

    Noelle Sisco: Absolutely. So at Napier Park, we feel like our real assets strategy, which predominantly consists of rail cars and aircraft leasing, is a strong complement to other private markets. So exposures to equity and credit returns have historically been positively correlated with interest rates and inflation rather than correlation to public market performance. And therefore we think that these assets and this exposure provides sound source of portfolio diversification. From a risk standpoint, one of the important benefits of investing into a diversified portfolio of a central use hard assets with contractual cash flows is that we see the associated returns as being quite durable historically. The assets are typically critical to the end users day-to-day operations, so they are rarely source of cost cutting given their absolutely paramount to the users against day-to-day operations, that's quite critical. And beyond that, we see, umm, we specifically favor mobile assets like rail cars that can be redeployed to new consumer if a default should occur. Overall, we see this space as one with credit like returns, but with meaningfully different drivers and therefore we consider it to be solid source of portfolio diversification.

    CJ Doherty: Some really good food for thought there, we’ll be closely following developments in the structured credit market next year to see how things play out. And with that, our time is up for today. Thanks for joining me, Noelle. It's been really informative and we hope to hear from you again in the future.

    Noelle Sisco: Wonderful thank you so much.

    CJ Doherty: And thank you all for tuning in. I invite you to check out our CLO news and analysis at loanconnector.com and also at our sister LSEG companies IFR and Yield Book which has market leading fixed income analytic solutions. I'm CJ Doherty, subscribe to the Lending Lowdown on your favorite podcast platform.

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