This publication recently interviewed Ariel Arazi, managing partner and co-founder of Bedrock, the private investment office based in London and Geneva. He discusses his views about the structured credit market.

Editor’s note: This publication recently interviewed Ariel Arazi, managing partner and co-founder of Bedrock, the private investment office based in London and Geneva. He discusses his views about the structured credit market.

Q. What sort of forms of structured credit do you mainly look at? Can you please give examples?

We are primarily looking at opportunities in US non-agency RMBS [residential mortgage backed securities] for the moment, as we believe this sector currently offers one of the most attractive risk/return reward profiles available in the structured credit arena.

Our highest conviction is currently cash-flowing, originally AAA-rated Alt-A paper. These bonds provide the principal recovery upside to draconian scenarios while concurrently exhibiting less uncertainty around monthly cash flows to comparable subprime bonds.

Q. How would you generally describe the market for structured credit at the present time? Is it improving/worsening?

The structured credit universe as a whole has experienced some macro-driven technical pressure over the last few months, but has fared much better than other “risk on” assets such as equities. Non-agency RMBS have been particularly robust, and overall prices remain close to their highs for the year.  This is in stark contrast to last summer and fall when the sector suffered tremendously as the macro picture deteriorated.

Given the amount of uncertainty in the world and the strong price performance of the non-agency RMBS asset class thus far in 2012, we do expect short to medium term pressure in price especially should the macro picture deteriorate. Having said this, the longer term outlook remains very attractive.

Q. What are the main drivers of the structured credit market at the moment?

At this moment, big picture macro concerns are weighing on the structured credit market as a whole. However longer term, the overhang of legacy assets continues to place significant pressure on institutions globally to deleverage and monetise/finance legacy assets.

Q. When do you see the market becoming more appealing again?

The structured credit market broadly speaking is already appealing, especially when comparing the yields on offer to other fixed income instruments. While we are somewhat cautious for the near term because of big picture macro risks, the long-term outlook is attractive. It should continue to be so as the US housing market recovers.

Q. How has the 2008 financial crisis and its aftermath affected this market? Are there any specific issues?

Pre-crisis: 92 per cent of US non-agency RMBS were AAA rated and dominated by banks, money-managers, insurance companies, and structured vehicles, such as SIVs and CDOs [structured investment vehicles and collateralised debt obligations].

Post-crisis, 95 per cent of US non-agency RMBS became junk-rated and more difficult to hold for real money; the pre-crisis structured vehicles have largely ceased to exist. This creates opportunities for investors.

Q. Where do you see there being opportunities, when, and why?

There are already tremendous opportunities and these will continue for the foreseeable future. This is largely because of the massive risk transfer opportunity of $3 trillion resulting from the need for banks to deleverage and shed non-performing/non-core legacy assets as they migrate to the Basel III / Volcker regime.

Looking forward we see four major opportunities:

1.       European banks selling programs of high-risk-based-capital securitized products in order to comply with new capital requirement legislation;

2.       Opportunities to participate with structurings/restructurings of attractive risk;

3.       Opportunities to acquire positions from traditional broker dealers as their balance sheets are reduced to comply with new regulation;

4.       The recovery in US housing combined with potential government programs aimed at bolstering the market that may lead to sharp changes in borrower performance assumptions.

Q. What remain the main risks here?

The risks for the non-agency RMBS sector specifically are limited liquidity, cash flow uncertainty and exposure to policy/regulation risk. For the whole structured credit market, macro risks and supply/demand pressures may lead to periods of declines.

Q. How does the experience of Bedrock's people shape the view of this firm towards structured credit?

Bedrock’s role is to identify investment opportunities and to select the best suitable managers to execute. Our experience with multiple asset classes and more sophisticated or complicated investments as well as our network of professionals help us take those views.

Q. Is the abuses scandal concerning LIBOR likely to have any impact on this market?

It is difficult for us to say with any conviction what may be the implications broadly for the structured credit market. In general however, if the crisis becomes much larger than it is at this stage, banks may need to sell assets at a faster pace, thus increasing supply. This may lead to technical pricing pressure.