Specialty finance emerging on resiliency, diversification: M&G Investments

As global investors are seeking ways to protect their investment returns in an inflationary, rising rate environment, some asset managers are eyeing an emerging, yet mature, asset class – specialty finance – of which the investable universe comprises an estimated $29 trillion of loan balances globally as of July 2022.

The high-running coupons and front-ended amortizing structures act as a protector, to ensure these investments remain highly cashflow-generative, said Jerome Henrion, head of specialty finance at M&G Investments, a London-based asset management firm and one of the largest alternative investment firms in Europe.

Specialty finance offers a sizable opportunity for long-term investors pursuing higher risk-adjusted returns. The return premium from the sector is generated by the relative lack of competition for assets and higher barriers to entry of the asset class, Henrion said to The Korea Economic Daily.

Businesses and consumers face headwinds in the current environment, so its sensible to assume that loan defaults could feasibly rise compared to the experience of recent years, although there are also reasons to believe that this could turn out to be a conservative view, Henrion said. 

The following is an interview with Henrion on Aug. 8.

▲ What is specialty finance and what are the principal routes of access for asset owners?

“Specialty finance offers direct exposure to consumer finance assets, including performing residential mortgages and consumer loans and credit – so, auto loans, unsecured personal loans, credit cards, student loans and opportunities such as mobile handset financing.”

“What many don’t realize is that specialty finance is actually a very well-established and sizable asset class, with an estimated $29 trillion of loan balances globally. In Europe, it’s only in the past few years that the investment opportunity has come about on any meaningful scale, by and large, due to multi-year regulatory changes within the banking sector.”

“Post-financial crisis and stringent capital requirements imposed on retail banks have meant that holding onto all of these loans has added to their capital burden, and encouraged banks to manage their capital ratios and balance sheets more efficiently.”

“Asset managers like ourselves have stepped in to acquire performing loan portfolios from banks or through partnerships with non-bank origination platforms and other consumer loan originators, and provide long-term capital to the market on behalf of investors looking to gain access to these high-quality loan assets.”

▲ Why are more institutional investors looking at the asset class and what are the key characteristics underpinning its growing appeal?

“Asset classes like specialty finance offer a sizable opportunity for long-term investors looking for higher risk-adjusted returns from their portfolio allocations. The return premium typically offered by these assets relative to corporate equivalents is generated by the relative lack of competition and higher barriers to entry of the asset class.”

“The high-running coupons and front-ended amortizing structures tend to act as a protector, to ensure these investments remain highly cashflow-generative. The risk-return profile is unique to each transaction and the purchase price of the pool is also important for return generation.”

“Further, if investors can invest in securitizations without facing punitive capital treatment, then strategies that use term financing (e.g. through issuing senior asset-backed securities tranches) can be an efficient, cost-effective and non-recourse way to fund the purchase of mortgage portfolios – and potentially offer investors access to higher risk-adjusted returns available from the asset class.”

“Part of the growing appeal of consumer finance among investors is down to its ability to offer diversification away from corporate risk. Most investors tend to have large exposures to corporate bonds, government bonds, equities, and maybe exposure to some private debt asset classes in their portfolios. Very few have direct exposure to high-quality consumer assets like residential mortgages. Our transactions are also diversified in nature because every time we acquire a pool of loans, it's hundreds, if not thousands of loans comprising the pool.”

▲ What are the risks of this asset class in the current environment?

“The main risk involved is higher-than-expected defaults feeding through to the underlying loan pools and leading to losses. For more than a decade, both corporate and consumer borrowers benefited from low-interest rates and a very low cost of capital. Now things are changing as central banks look to raise interest rates to control runaway inflation. In general, higher interest rates and a higher cost of living may negatively impact consumers’ ability to service their debts, which could lead to higher defaults compared to the experience of recent years.”

▲ Despite the potential risks, are there any reasons to believe that consumer finance assets could prove to be resilient given rising inflation and interest rate hikes? 

“I would say there are three main reasons. The first one is the vast majority of consumer assets are fixed rated. Borrowers who have fixed their initial rates won’t see an immediate increase in their monthly loan repayments, particularly if nominal wages are somewhat correlated with inflation.”

“Refinancing risk inherently increases at the reset date. While initial mortgage ‘teaser’ rates of two, three and five years tend to be the norm in the UK, in many European countries, long-term, fixed-rate mortgages are common, with borrowers opting for fixed-rate loans which have reset dates that can be more than 20 years away.”

“The second one is low duration risk. Consumer loans have the potential to offer attractive short-dated, income-driven returns with low levels of duration. While consumer assets are fixed rated, the structure can be hedged to a floating rate for investors to provide rising returns as interest rates increase.”

“The last one is that collateral values tend to appreciate in an inflationary environment. If house prices secured against mortgages also remain correlated with inflation, this could potentially provide greater levels of protection against loss in the event of default.”

“As well as default risk and loss severity, other risks include pre-payment risk. Higher rates should lead to lower prepayments which can either be positive or negative for returns depending on the purchase price of the mortgage portfolios originated.”

“Consumer finance is a data-rich asset class and data forms a critical component of our investment process, enabling very detailed risk-modeling and scenario analysis that can be calibrated to reflect any future economic environment. We take a prudent approach when underwriting mortgage and consumer loan pools and apply conservative assumptions, including higher defaults and losses relative to long-run averages, higher prepayments and higher costs, in our modeling.”

“An ability to set parameters for these transactions, including structuring loan portfolios according to specific criteria and characteristics that are agreed on upfront, can enable positive credit selection and potentially ensure that default rates and therefore losses remain low.”

▲ If signs of a global economic slowdown become more apparent, could this negatively impact the performance of consumer credit?

“A tougher economic environment could stand to challenge corporate profit margins in a climate where costs are also rising and supply is constrained. However, while consumers face headwinds in the current climate, there are several factors in play which are helping to underpin the creditworthiness of borrowers.”

“Households in developed economies have significantly de-levered since the global financial crisis and the post-crisis regulatory reforms introduced on lenders have made consumer loans such as mortgages both safer and stronger, which has helped to guard against a significant increase in the number of highly-indebted households.”

“Many households also entered this year with much higher savings than at any point in several decades, due to the unusual monetary and fiscal policies we have had and the change in consumer behavior during the lockdown. Governments across Europe have moved in the first half of this year to announce further financial support for households in the face of higher energy prices and the rising cost of living – to ensure they remain central to the functioning of economies.”

“Borrowers who take out conventional consumer credit like mortgages tend to be concentrated in higher income brackets and are, generally speaking, proportionately less impacted by downturns. For an economic slowdown to bite, it needs unemployment to rise. In contrast, unemployment rates in many developed economies have fallen to multi-decade lows. So, even if real wage growth is negative for now, the fact that much of the population is employed is a huge positive.”

“This is a very data-intensive investment strategy, and it’s worth highlighting that we use the large volumes of raw loan data that we receive with each pool, together with market data and data on consumer behaviors, to generate likely default probability and loss severity of the loans underlying the portfolios. This enables us to determine an appropriate purchase price to assume these risks and generate the desired level of return for our strategies.”

▲ How do US and European consumer credit compare?

“European residential mortgages are quite different from US ones, since in Europe, origination is bank-led whereas the US is more of a ‘market-based’ system with a greater share of non-bank originators and servicers. This means that banks in Europe lend to retain and have a vested interest in how loans perform over the long term. Also, European mortgages have recourse to borrowers unlike in the US.”

▲ Where do you see the most interesting opportunities?

“We are seeing a number of interesting and diverse opportunities to deploy across the residential mortgage and consumer loan universe and across jurisdictions.”

“The advantage of investing in residential mortgage and consumer loan portfolios across the OECD is that it provides broad diversification in terms of regions, originators and servicers – particularly as more non-bank lenders enter markets dominated by traditional banks. Of course, markets with fewer lenders can offer particularly attractive spreads for loan portfolios.”

▲ Given your specialized focus on this sector, what is your long-term view on the asset class?

“We believe it offers a long-term, structural allocation opportunity for institutional investors to gain access to what are high-quality bank loans, offering diversification potential away from corporate risk and higher risk-adjusted returns compared to equivalent-rated corporate bonds.”

“The asset class is very scalable. As bank balance sheet deleveraging is set to continue amid increasing regulatory pressure, asset sales of core bank lending assets only look set to accelerate from here.”

“As banks have become risk-averse and reduced their lending activities in certain segments, non-bank players, often tech-savvy, are stepping up to fill the gaps. This has not only created an opportunity for institutional capital to fund and form origination partnerships with these innovative platforms to allow them to grow their market share, but could help to disrupt the status quo and create a more diversified lending landscape to develop in Europe.”

M&G Investments is a global asset manager, serving customers for nearly 90 years since launching Europe’s first ever mutual fund in 1931. Part of M&G plc, the firm manages assets of over $439.5 billion as of end-2021 in equities, multi-asset, fixed income, real estate and cash for its customers and clients in the UK, Europe and Asia.

Henrion joined M&G in August 2017 to head the investment firm's newly established Specialty Finance fund platform within its Alternative Credit division. In this role, his focus is on the origination, screening and risk/return analysis of investment opportunities within the Specialty Finance fund platform.

Prior to joining M&G, he served in a number of leadership roles at Credit Suisse over the past 21 years, most recently heading the EMEA Solutions Coverage Group and acting as a member of the Global Markets EMEA Operating Committee. In this role, he was heading the team responsible for originating loan portfolio opportunities in Europe, advising buyers or sellers of loan portfolios, and/or financing the buyers, or helping bank owners of loans hedge their portfolios.

Previously, Henrion ran the Financial Institutions Solutions Group, the Financial Institutions Debt Capital Markets Group and the Asset Backed Securities Sales team. 

Henrion has a Master’s degree from the Solvay Business School (ULB) where he received a degree in Commercial Engineering, Magna Cum Laude.

Write to Chang Jae Yoo at yoocool@hankyung.com
Jihyun Kim edited this article.