What is structured credit?

Hi, I am Jim Smigiel, SEI's chief Investment Officer, and I'm here today to talk to you about structured credit. 

Probably the best place to start off is, well, what exactly is structured credit? Structured credit is a well-established, diverse, and large market. The economist recently estimated that the structured credit market lands at roughly around 3 trillion and growing as of the end of 2023. It offers potentially attractive risk adjusted returns and floating rate payments that limit interest rate risk when compared to traditional fixed income instruments. 

The key to understanding any structured credit product is familiarity with the securitization process. This is similar across all structured credit vehicles, whether they be backed by mortgages or credit card receivables, or debt obligations like collateralized loan obligations, just to name a few. But for the purposes of this discussion, we will be focusing on those collateralized loan obligations or CLOs. 

To illustrate the concept, CLOs represent a massive portion of the structured credit marketplace. Bank of America has recently reported that this market has topped a trillion dollars in assets as of the end of 2023, and today it's really on par with the size and liquidity of the high yield bond market itself. 

At SEI, we have a long history with CLOs as we've been investing in them since 2005. A CLO can be described as a simple corporation that purchases hundreds of bank loans issued by corporate borrowers. These borrowers are household names that we're all familiar with, such as American Airlines or Liberty Global, and these loans are the assets on the CLO balance sheet. The CLO then pools them and offers investors access to that pool through various tranches or securities with differing risk return profiles. If you think back to your intro to accounting class, the assets are financed by liabilities. In the case of a CLO, the liabilities are the various debt tranches issued by the CLO and purchased by investors that depends on each investor's investment objective and risk tolerance. 

Remember, a CLO is like a simple corporation governed by a hierarchy in which it must repay debt obligations, in this case, AAA to single B tranches. Rating agencies such as Moody's or s and p evaluate and rate these tranches based on the quality of the underlying collateral and the tranches priority in the receipt of principal and interest payments. A typical CLO is structured such that the higher rated tranches receive interest and principal payments from the underlying loans ahead of the lower rated tranches. 

As a result, the lower rated tranches absorb defaults before the higher rated tranches. It's worth noting that this structural subordination provides risk mitigation for the most senior tranches. In fact, as of the end of 2023, no AAA rated CLO tranche has ever defaulted even during the global financial crisis of 2008. The equity tranche is certainly a misnomer as there are no equities in a CLO. All other leftover income goes to the shareholder's equity, which is the equity tranche. Put simply, the equity tranche is the accrual of profits, less the CLOs financing expenses. Equity T tranches are attractive to more risk tolerant investors as they offer the highest potential returns by extension, though the equity tranche will also take losses first if the loans default on their payments to the CLO.