Q&A: Structured Credit

Michael Gubenko: How would you characterize the structured credit market today?

Udai Bishnoi: I think this is a really interesting environment for structured products. Over the last 10 years underlying interest rates were low, but in today's environment you can construct your investment so that you can expect a higher yield and higher credit enhancement at the same time, which wasn't present in the past decade.

Security selection, however, will be the key as the macro uncertainty requires you to underwrite the right risk, even though the compensation that you're receiving in terms of yield on an entire sector is much higher than in the past, but the credit concerns are also higher. So, in my opinion, this will be the environment where you will be able to separate between people who do more fundamental credit work, versus managers who are pro-cyclical and invest based on easy money.

Michael Gubenko: Where are you seeing the most attractive opportunities to invest?

Udai Bishnoi: On the surface, spreads are wider across the capital stack and across different sectors in structured credit. But in the end, there will be more variation in returns as different parts of the capital structure and different sectors go through a different credit environment. Currently, our focus has been on safer, top of the capital stack investments or even the belly of the capital stack. If we were to go sector by sector, I’d say we are seeing more opportunities in the residential markets today but expect to see opportunities in CRE in 2024 and beyond as over-levered structures look to refinance in a higher interest rate environment. We like many fundamental aspects of the housing sector, and so for returns, especially on a risk-adjusted basis, we are finding good opportunities to invest.

Michael Gubenko: What gives you a sense of why a housing market cycle is not a concern in the residential space?

Udai Bishnoi: I think there are a lot more factors favoring housing than there are going against it. For example, most of the concern circulating today is around affordability and yet when I think of residential mortgages, we are looking at borrowers who already have an existing loan. We don't expect much default activity from existing borrowers as affordability is not an issue for them. It's an issue for a new borrower. So that's one to begin with. While we estimate the housing market can go down another 5 to 10%, that is not going to change the behavior of existing borrowers. When we take into account other factors like supply shortage and the fact that the loan amount or the interest rate for most of the borrower’s outstanding today is inside 3%, this all points to a stronger housing market and lower defaults. And so, it is our collective conclusion that supply, which was a concern during the GFC, does not exist today.

Michael Gubenko: And then separately, are there any areas that we're avoiding?

Udai Bishnoi: It is very hard to name a particular sector that we are avoiding outright. Unsurprisingly, we are very cautious about office space as it will have multiple binary outputs. We think the health of unsecured consumers, specifically non-prime or subprime, is a concern as inflation hits those borrowers most aggressively. For CLOs we are concerned about certain specific loans or industry types. But in totality, it is very hard to single out one particular sector. It's all very specific, bond by bond, structure by structure. If I were to say I'm more concerned about bonds in lower parts of capital stacks, that's an easier way to define my risk tolerance than a particular sector.

Michael Gubenko: You mentioned concerns around office. When you think about those concerns, how do they manifest in what we are doing or won't do in the CMBS world?

Udai Bishnoi: Office is a very difficult sector. What we are focused on is the year of construction and location. We like newer buildings and prefer modern, well-located buildings at the right price. We think those office properties will do better than either commoditized suburban office or older buildings which are still classified as class A but that may be at a disadvantage versus buildings with more amenities or buildings with a better location. Some of the risks are very obvious and well known. And so while those risks are being priced in perhaps to the extreme for many deals, there’s a lot of inconsistency in the market and we are seeing a lot of other deals which we would call un-investible and are staying away from.

Michael Gubenko: How does the Sculptor investment model, and particularly having colleagues who are focused on the private real estate markets, aid in our process across securitized products?

Udai Bishnoi: Our platform provides us with a few main advantages. The first is in our underwriting as we have developed analytical systems over the last 15 years, which we continue to improve, and which capture our collective expertise across the firm. In terms of collaborating with our private real estate team, we are in constant dialogue with them on a day-to-day basis. By sitting together and developing a better understanding of what’s happening on the private side of the market, we can then apply that understanding to how we underwrite various bonds.  Working together allows us to be more selective and to be better in our fundamental credit underwriting.

Michael Gubenko: What are some of the things that are dominating markets,, in particular the banking crisis earlier this year? Is there anything that has surfaced from that episode?

Udai Bishnoi: In my opinion, the banking crisis of 2023 is quite different from the GFC. This time around, it was a duration driven crisis, and so the banks that have ended in receivership so far, do not have portfolios which have a lot of credit related risk. The FDIC did a good job of controlling the liquidation and sale of those portfolios. So the impact in terms of buying from a forced liquidation was not necessarily there. But that does not mean in the near term or in the medium term, this banking crisis will not create opportunities especially given banks’ balance sheets, which have a lot of gaps due to asset liability mismatch. As an outcome of this we expect banks to curtail their lending in many sectors, and that should provide opportunities for private investors like Sculptor to be the source of funding.

Michael Gubenko: How does our investment platform help us to be active in this market?

Udai Bishnoi: We have two important elements to help us in this market. The first is sourcing, and the second is underwriting. On the sourcing front, our platform is very diverse. We have an equity group, we have a credit group, we have a real estate group and a structured products group. So, we see opportunities come from multiple fronts. Because we have been doing this for 15+ years and because of our robust platform, market participants know us as a great underwriter of different types of risks in the structured credit space.

Not many other firms have been around for the same period of time as us and have been able to underwrite the variety of risks across all asset classes so well, especially more complex, and esoteric investments.  So, we expect to be, if not the first call, definitely in the top five calls from different issuers.