Alyssa Irving, fixed income portfolio manager at Wellington Management, talks about the asset manager's work in 2022's structured debt environment

How has Wellington helped clients navigate the volatile environment of 2022?

The significant increase in rates this year has resulted in sizable unrealized losses in fixed income portfolios. At the same time, this environment has created opportunities to earn attractive yields that we haven't seen in over a decade. We have worked closely with our clients to position their portfolios to take advantage of these higher yields while minimizing realized losses.

We have also placed a greater emphasis on our downside scenarios for our clients' securitized holdings to reflect the weaker economic growth outlook and substantial increase in rates. These scenarios help us identify securities that could be at higher risk of credit deterioration and potential downgrades. It is our job to ensure that we are monitoring and managing the risks in their portfolios, and we don't want there to be any surprises in our clients' portfolios.

Throughout the year, we have been producing timely content with our views and how clients could take advantage of market dislocations.

Which areas of structured debt have you seen most promise in the last year?

Given our expectations for continued upward pressure on rates, we have preferred floating rate securitized assets, such as Collateralized Loan Obligations (CLOs) and single-asset single-borrower Commercial Mortgage-Backed Securities (CMBS). These securities are less sensitive to interest-rate moves because of their floating rate coupons, and their total returns have held up considerably better than fixed rate assets on the back of rising rates. Additionally, floaters have generated more income thanks to the Fed's rate hiking cycle since their floating rate coupons reset higher with short-end rates.

Within the Residential Mortgage-Backed Securities sector, seasoned agency credit risk transfer securities (CRT) have also stood out. Despite dim prospects for future home price given the surge in mortgage rates, the seasoned mortgage loans underlying these securities have benefitted from years of strong home price appreciation. Additionally, these deals have also delivered substantially through high principal prepayments during the low-rate environment, which built up their credit support. Even our worst-case scenarios where home prices decline much more than expected, these securities hold up well from a credit perspective, furthering our conviction in seasoned CRT investment for our clients' portfolios.

How can insurers rely on structured debt to counter the continued volatility in the market?

Structured debt is an important part of our fixed income toolkit. It provides multi-sector portfolio managers another valuable relative value lever to pull versus other credit sectors, particularly corporate credit. Structured debt also provides diversification benefits vs other asset classes. It has exposure to particular parts of the economy and can have sector-specific performance drivers, lessening the degree to which they move in synch with other fixed income credit sectors. Additionally, the structured market is comprised of a large and diverse universe of risk and return profiles.

The variety of collateral types gives clients the opportunity to choose exposure to different economic drivers such as consumer, commercial real estate, and residential housing, as well as some of the more esoteric sectors (e.g., equipment, container, etc.). The collateral itself also benefits from diversification as deals are backed by many borrowers. Different structural features and cash flow profiles further enhance diversification.

Another unique feature of structured debt is the ability to naturally deliver over time, reducing credit risk. Most collateral pools are amortizing with principal cash flows applied to paying down senior bonds. As senior debt pays down, credit enhancement rises, reducing default risk. This is an important characteristic especially if the market volatility is driven by concerns around weakening economic growth. Lastly, structured debt is largely a domestic asset class which means that it is less exposed to negative shocks/events that occur outside the US unlike corporate bond markets which are more tied to the global economy.

How do you envisage the market incorporating new factors into it in the coming years-- ESG for example?

We believe ESG will become a bigger focus for some of our insurance clients and our climate research team is already working with some of them to help bring ESG and climate change into their processes and portfolios upon request. Wellington has partnered with the Woodwell Climate Research Center on physical risk, and the Joint Program on the Science and Policy of Global Change at the Massachusetts Institute of Technology, on transition risk with the aim to bridge the information gap between climate science and the financial markets.

While structured debt is early on in its ESG journey relative to other asset classes, we expect it to gain more momentum over the next several years. We believe we are further along than most as our securitized credit research team has made significant inroads toward developing ESG materiality frameworks for each of the main securitized sectors. The team is also leveraging the firm's ESG resources in scoping out projects and tools that can serve as an additive input to the research and investment process.