Structured credit offers investors an appealing blend of portfolio diversification, potential for yield and risk management, writes David Favier.
Some analysts refer to this sector within the fixed income asset class as securitised credit – here, these terms are used interchangeably.
How it works
- Asset pooling:
A financial institution bundles or pools a group of homogeneous financial assets such as consumer, mortgages, or credit card loans into a special purpose vehicle (SPV), i.e., a separate legal entity.
- Tranche creation:
The SPV then issues securities which are divided into tranches based on risk and seniority1 and sold to investors who receive payments (principal and interest) generated by the cashflows from the underlying assets. Each tranche has unique characteristics, including the risk level, interest rate, and maturity. This allows investors to tailor their investments to their specific needs and risk tolerance.
- Risk allocation:
Senior tranches are less risky and typically have higher credit ratings, i.e., credit protection is provided by the lower tranches. These are first layer to bear any losses arising from defaults in the underlying loans. They are therefore riskier and generally offer higher yields.
- Priority of payments:
A ‘waterfall’ structure defines the order in which payments from the underlying assets are allocated to the different tranches.
- Senior tranches are the least risky, having first claim on the cashflows from the underlying assets
- Junior tranches are riskier, having a lower claim on the cashflows, but may offer higher yields
- Mezzanine tranches sit between senior and junior tranches in terms of risk and return.
This protection whereby senior tranches only begin to bear credit risk losses once the junior tranches have been written down to zero, combined with portfolio diversification benefits, can make structured credit an attractive option for investors focused on managing risk in their portfolios.
Why is securitisation important?
Securitisation is important because it enhances efficiency within the financial system by transforming illiquid assets into tradable securities, enabling risk transfer, capital relief, and funding diversification.
For banks, it frees up balance sheet capacity to support new lending and reduce potentially risk weights. It offers investors access to granular credit exposures with tailored risk-return profiles.
Investing in securitisation is a means of financing the real economy, securitisation markets being a key funding channel for the economy, especially at times when bank lending is constrained.
Other benefits include reduced financing costs for households and companies. Since securitisation is based on extensive pools of assets often from different business sectors or geographic regions, the risks attached to the underlying assets are diversified either in terms of geography or business, or both.
Is securitisation safe?
For some investors, securitisation still suffers from the stigma associated with its misuse before the 2008 financial crisis (in particular, securitised US subprime mortgages).
Securitisation is secure when it’s transparent, well-structured, and properly regulated. The 2008 crisis was, in our view, not caused by securitisation itself, but by poor underwriting and a lack of transparency – especially in the US subprime sector. European securitisation, in contrast demonstrated a strong performance despite the crisis.
The development of a simple, transparent and standardised securitisation market constitutes a building block of the European Union’s Capital Markets Union (CMU) and contributes to the European Commission’s priority objective of supporting job creation and sustainable growth.
The EU’s Simple Transparent and Standardised (STS) framework of 2017 aims to ensure a high-quality securitisation market that:
- Improves the financing of the EU’s real economy
- Enhances private risk-sharing
- Ensures investor protection.
Reflecting the high-quality nature of EU securitised debt, STS assets were classified as eligible for inclusion in the ECB’s Quantitative Easing programme.
We believe it is important for investors to now recognise that European securitised assets are fundamentally different from their US counterparts: lending standards are higher, and there is improved recourse to the original borrower. ABS, as an example, has expected cumulative lifetime loss rates of 1.0% in Europe compared with US loss rates of 7.3%.2
A broad range of European regulations and industry initiatives implemented since the 2008 crisis ensures better alignment of risk between issuers and investors:
- Regulatory framework
The EU Securitisation Regulation introduced stricter requirements, including the STS label. This has helped reinforce investor confidence and resulted in a resurgence of European structured credit in recent years, with record levels of new issuance.
- Increased transparency
The SECR mandates more transparency and disclosure requirements, ensuring investors have access to detailed information about the underlying assets and their risks.
- ‘Skin in the game’
Financial institutions that originate loans are required to retain a 5% stake in the securitised asset, incentivising them to have high lending standards and manage risks effectively.
Benefits of structured credit for investors
Access to a wider range of investment opportunities: Structured credit products are backed by a pool of different loans, exposing investors to various parts of the economy. This diversification helps reduce the overall risk of the pool and its sensitivity to market fluctuations. A pool of diversified underlying assets also contributes to stable cashflows.
According to AFME data from December 2024, the outstanding stock of European securitisations amounted to €1.15 trillion, with diversified exposures to private debt.
Significantly higher yield pickup over equivalently rated conventional corporate bonds across rating bands.
Reduced interest rate risk: Almost all the listed structured credit products pay floating interest rates, i.e., coupons adjust periodically in accordance with movements in short-term interest rates. This results in near-zero interest rate risk.
This is unlike traditional fixed income instruments: fixed coupon rates means they are susceptible to changes in interest rates and inflation expectations.
Risk management and credit protection: Traditional corporate bonds are backed by the creditworthiness – and exposed to the default risk – of a single issuer. A diversified pool of loans provides more protection in the event a single borrower defaults. As an example, a pool of car loans often comprises more than 100,000 loans, a residential mortgage-backed security typically comprises around 10,000 mortgages.
Liquidity: European structured credit trades in a relatively liquid secondary market, especially compared to that for private credit.
Increased transparency has been provided by better regulation and the provision by the ECB of a European data warehouse, where investors can access all the data available on the pool as well as the legal documentation governing the SPV and structure. As a result, investors are better able to assess risk and understand transactions before buying. This can contribute to market liquidity.
Comparing US and European structured credit
One of the main differences is the US mortgage-backed securities segment which is significantly larger and more liquid than its European counterpart. There is no true sub-prime market in Europe. The US RMBS market focuses on sub-prime because the prime market largely conforms to agency lending standards, i.e. those set by government-sponsored agencies such as Fannie Mae and Freddie Mac.
Other differences:
Stronger regulatory framework: The ECSR’s ‘skin in the game’ requirement aligns the interests of originators and investors. As a result, European ABS defaults have typically been lower than those in the US.
Impact of recourse: Many European structured credit structures include provisions for recourse to the original borrower, i.e., the lender can seek reimbursement for losses from the original borrower if the underlying assets default. This mechanism helps mitigate risk and contributes to lower loss rates.
In the US, ABS structures may have recourse provisions depending on the type of asset and the specific deal structure. This variability can lead to higher loss rates in cases when there is no recourse.
An example would be the treatment of mortgage defaults.
In the US, homeowners facing difficulty with mortgage payments can often return the keys to the lender without personal recourse even if the property value falls short of the outstanding mortgage.
Conversely, in Europe, lenders have full recourse to a borrower’s other assets. As a consequence, European borrowers typically prioritise mortgage payments over other financial obligations, resulting in a more stable and predictable market.
Outlook for European structured credit
Looking at the market for ABS auto loans, we saw almost €28bn of new issuance in 2024 and we expect a similar level for 2025, reflecting stagnant new car sales across Europe. While this segment has shown modest weakness, we believe the most significant headwinds affecting households in Europe have now subsided. Consequently, the outlook appears more positive.
On consumer loans and credit cards, European Union (EU) and UK consumers had to face high debt servicing costs and persistently high cost of living throughout 2024, requiring them to draw down their savings. For 2025, some pressures may remain, but the fall in interest rates and gradual improvements in real income levels can be expected to support consumer credit markets.
For corporate credit, we expect to see a shift to idiosyncratic developments amid generally healthy refinancing volumes. We expect CLOs to do well, with senior tranches outperforming the broader credit market. Opportunities may be seen across BB rated tranches.
The EU/UK RMBS market grew by 55% in 2024, reaching total issuance of €44 billion. We expect another strong year in 2025. In terms of performance, the prime residential mortgage-backed securities sector has shown resilience despite relatively high interest rates. With rates now beginning to trend down, there should be further support for overall performance.
We believe that in the current context of uncertainty over the outlook for the US, it may be beneficial for investors to diversify their investment focus – especially to Europe. Structured credit would be a good option due to attractive spreads and performance expectations. The regulatory framework and the propensity for European consumers and borrowers to pay down debt underpins the strength of European securitised debt market.
Conclusion
Investors have come to value European structured credit because it allows them to enhance yields and diversify portfolios.
Investing in European structured credit offers exposure to diverse parts of the economy, distinct from the corporate bond market, and can help reduce overall portfolio risk.
With a more positive outlook for European consumers and borrowers, we believe European structured credit looks well set to be a promising segment in the global fixed income landscape.
[1] Junior tranches, which carry greater risk, but have higher potential returns, are paid after senior tranches.
[2] Source: Structured Finance Losses 2000-2014, Fitch Global, 7 February 2015
