Analysis

K E Y N O T E

I N T E R V I E W

Assessing credit opportunities
through a quant lensCombining data analytics with deep expertise is key to identifying the most attractive
opportunities, including through the covid-19 dislocation, says Marianna Fassinotti,
managing director at the D. E. Shaw group

Q

What motivated theD. E. Shaw group’s
participation in the credit andstructured credit markets?
How does the group’s quantexpertise help you navigate
these markets?

We have been active in credit
markets since 1989, first throughour participation in the convertible
bond market and later in a broader
mix of credit strategies across public
and private markets. What has madethe credit markets compelling for
us is that although they are broadbased and global in nature, theyoften feature distinct local attributes,
disparate sectors, and instruments

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SPONSORD. E. SHAW
with complex, esoteric structuralfeatures, and require an investor toassess and interpret many data inputs.
Those elements combine to create
real barriers to entry and fit well with
our quantitative and highly analytical
approach to investing.
For example, in the structured
credit markets, an investor needs
access to a lot of data and proprietary modelling technology. Our Asset-Backed Strategies investment unit
has a dedicated tech and data analysis
group that aggregates and remediates• July/August 2021

data, but also synthesises and analyses
it with our investment team. We believe this approach allows us to uncover opportunities that may not havebeen obvious to others, or to identify
mispricings well before others.
Over the years, we have successfully applied this data-driven, technology-enabled investment approach to awider menu of credit and credit-related assets, allowing us to pursue a multi-strategy credit approach that can beflexible as market conditions evolveand intra-market dynamics shift, andhave built teams dedicated to specificareas of credit, such as asset-backed
securities, convertible bonds and corporate credit.

AnalysisQ

How would you describe
the general state ofstructured credit markets in theUS and in Europe?

Generally speaking, at the moment wedon’t see widespread areas of opportunities in public credit markets, including in structured credit. That said, weare currently monitoring more nicheand esoteric parts of the structured
credit markets, particularly in Europe.
Traditional securitisation markets
in Europe are significantly smaller andless mature than those in the UnitedStates. However, Europe has an active
and growing synthetic securitisation
market, which allows banks to transfer
credit risk exposures and reduce associated regulatory capital requirements
without actually selling the underlying
assets. We believe this marketplace hasroom to mature in a number of areas,
and that participation requires deep
knowledge of underlying assets as well
as structural expertise in understanding covenants, cashflow waterfalls andvarious triggers similar to those in the
traditional securitisation markets.
In the US, opportunities in thestructured credit markets have been
and continue to be episodic or fleeting
since the fall of last year. It’s also worth
noting that this is a very large market
that can quickly produce idiosyncratic
mispricings due to tactical withdrawals
and/or broader rebalancing activities
by asset managers, particularly mutual
funds and REITs, whose participation
has increased dramatically since the2008 Global Financial Crisis. For thisreason, we believe the current environment benefits managers with agile
investment processes and efficient decision-making frameworks.

Q

How do you evaluate theprogress of the European
banking system in cleaning
itself up in the years since theglobal financial crisis?

Unlike in the US, where banks historically have securitised and/ortransferred credit risk into the capital

QHow did you react to the initial market stress that
resulted from the covid-19 crisis?

When presented with a large market correction, we often begin by thinking
about the right risk benchmark. The temptation is to look at the last crisisand extrapolate from there. Because the catalyst of the 2020 crisis was adefined exogenous shock, we believed that observing how consumers andother market participants reacted to sudden disruptions caused by pastnatural disasters would provide more relevant insights than the experiencesof the GFC.
For example, in March 2020, residential mortgage-backed securities,
particularly government-sponsored enterprise credit risk transfer bonds,
came under enormous pricing pressure, with most CRT bond prices fallingwell below par. Given the limited history available for CRT bonds, we useda proprietary database containing loan-level information on more than
50 million agency mortgages to mimic the credit profiles of existing CRT
bonds.
In fundamental terms, the situation entering the 2020 crisis was alsoquite different than that of the GFC – home prices increased in recentyears, suggesting that loan-to-value ratios for recently issued mortgages
had actually decreased post-origination, and measures of the condition of
the housing market and household health were strong entering 2020. As aresult, in the current crisis, borrowers had options at their disposal otherthan default, including selling properties or modifying loans.
Based on our analysis, we believed that the underlying credit profilesof CRT bonds were more resilient than was assumed by many othermarketplace participants, who may have over-relied on experiences fromthe GFC in their assessment of these securities.

July/August 2021

• Women in Private Funds37

Analysis
markets, banks in Europe are both primary originators and holders of credit risk. Given many European banks’
weaker capital positions at the outset of
the GFC and limited options for generating capital in subsequent years, thebanking system’s ‘clean up’ remained
incomplete when the pandemic hit.
The pandemic has effectively put ahalt on the deleveraging activity of theEuropean banking system, while also
creating an environment conducive toproblematic-asset formation; we believe
non-core assets on bank balance sheets
may track upwards again, effectively
slowing, if not reversing, the deleveraging. At the same time, we expect theregulatory thrust towards shrinking exposure to non-core assets will resume,
potentially creating new opportunities.

QHow would you assess thegeneral risk environmentin credit markets in recentyears?

We believe that central bank intervention in the larger syndicated public credit markets for both corporates
and structured credit has meaningfully
reduced return opportunities in thoseareas; the more liquidity a specific market has received from a central bank,the less attractive it appears from an
opportunistic credit perspective.
By contrast, private credit markets’
access to capital and liquidity has notbeen as robust. In general, this tends
to benefit those investors with broader
credit mandates and the ability to pivot
to attractive opportunities across bothpublic and private credit markets.

QIn what ways are theGFC and the more recent
covid-19 crisis similar? How dothey differ?

The proximate cause of the current crisis was an exogenous shock, not something inherent to the financial system,as was the case with the GFC.
Another important distinction isthat, unlike the GFC, which primarily involved banks and households, the38

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most vulnerable sectors leading up to
the current crisis were non-bank financials and corporates. In recent years,
lower yields have compelled mutual
funds, REITs, and other non-bank financials to invest in riskier and lessliquid assets. As a result, these investors
became a larger source of funding fornon-financial firms, and often by meansof very short duration capital structures,
creating an asset-liability mismatch.
Typically, we would expect crisis-related liquidations initially to involve assets moving from leveraged investors tounleveraged, traditional asset managers(such as mutual funds or pensions), or to
the Fed. In this case, while we did witness some forced selling by leveraged
investors such as hedge funds and REITS, the more interesting early-stage
activity stemmed primarily from mutual fund liquidations sparked by retailinvestor redemptions, which were acutein credit and structured credit markets.
That is not to say there were nosimilarities between the crises. Onceagain, we were reminded that highly
leveraged financial systems are vulnerable to unexpected shocks, and that liquidity events can quickly become solvency events. We also observed that theareas most impacted by the initial liquidations appear to be those that may
have benefited most from easy financial
conditions and a ‘risk-on’ sentiment.

QHow do you see the private
debt market evolving overthe medium term?

In recent years, large monetary and fiscal stimulus programmes have contributed to reducing volatility and keeping
credit spreads tight. Indeed, with credit
spreads well below historical averages, most public credit segments ended
Q1 2021 in their lowest decile of yields
ever. As a result, we believe that thelarger syndicated public credit markets
currently offer very few attractive absolute or risk-adjusted return opportunities. This is not to suggest that the moreesoteric public and private credit markets are completely immune to macro• July/August 2021

“In the structured
credit markets, aninvestor needs accessto a lot of data andproprietary modelling
technology”

pressures, but in general the further out
one looks in terms of liquidity and access to monetary or fiscal stimulus, theless resulting distortion one sees.
We do believe opportunities exist
in parts of the corporate debt market, particularly in the lower end of
the mid-market and in small and medium-sized enterprises, as well as incertain segments of the real estate market. Potential mispricings exist either
because stimulus did not reach these
credits and assets, or because the recovery story is not easy and obvious. Weview those areas as laggards in somesense, because the shape of their recovery curve has been more muted.
To tackle the issues faced by theseparts of the market, we believe twothings are needed. The first is flexible
capital. Direct lending strategies havebeen a huge engine of growth in private
credit, but this market hasn’t historically provided flexible lending on bespoke
terms of the type one would normallysee from distressed debt or special situations players.
Second, we believe the market needs
longer-duration capital. Regulatory
pressure has reduced banks’ appetite
for concentrated exposure in the middle and smaller credit markets, where
they are mostly interested in lendingin very liquid forms. Combined, thesecan create compelling opportunities
for agile players able to provide capitalsolutions with an appropriate durationand structure of capital. nThis article was sponsored by the D. E. Shaw group. It is being provided for your information only and does
not convey investment advice or an offer of any type with respect to any securities or other financialproducts. Please note the date of this article, as the information contained in it has not been updated for any
information that may have changed. No assurances can be given that any aims, assumptions, and/orexpectations expressed or implied in this article were or will be realized, or that the activities described in thisarticle have continued or will continue at all or in the same manner as described. This article is distributed withpermission from Private Debt Investor.