Structured Credit: Supercharging Spread | Insight Investment

Fixed income investors are enjoying historically high absolute yields but are contending with historically tight credit spreads.

ABS, however, may offer the best of both worlds: relatively high yields and spreads. We see the most compelling spread opportunities outside the Bloomberg US Aggregate Bond Index (the “Agg”), particularly in less traditional “esoteric” ABS sectors (Figure 1).

Figure 1: Structured credit can offer a yield premium over comparably-rated corporate bonds¹

We highlight three examples of assets that we believe may enhance a Core Plus or credit strategy.

Esoteric ABS – financing innovation

Esoteric structured credit is the fastest-growing “non-traditional” fixed income market, with ABS deals often collateralized against unconventional asset pools. Their spread premium reflects complexity rather than additional credit risk, as credit ratings typically range from AAA to BBB. Two sectors that may be particularly compelling are data centers and whole business securitizations (Figure 3).

Figure 3: Esoteric structured credit may offer a substantial “complexity premium¹

Data centers – the digital age is not just an equity story

As the world braces for a potential “AI revolution”, digital infrastructure (which includes data centers, cell towers and fiber-optic cables) is hungry for finance. The structured credit market is playing a key role.

Data centers are the backbone of the internet. The “cloud” is in fact a network of physical facilities that store, process and distribute millions of gigabytes per second. They make technologies like 5G, big data, real-time analytics and video streaming possible.

Cloud computing has been a key driver of the data center build-out in recent years. As 89% of large businesses embark on digital and AI transformations, migrating in-house computing systems to cloud providers has become a key step (Figure 4)³. Companies can lease anything from data center shelf space (known as retail “colocations”) to entire buildings (known as “hyperscale” data centers). ABS deals tend to be secured against leases from multiple tenants and other assets while CMBS deals tend to be secured against a single borrower’s mortgage on a data center.

Figure 4: Demand for data centers has been growing rapidly⁴

We tend to favor ABS deals over SASB structures, and our focus is on long leases to investment grade tenants. A potential example is a Vantage Data Centers⁵ ABS deal in October 2024 backed by certain hyperscale data center tenant fixtures and leases.

The next phase of investment is being driven by computationally intensive generative AI systems like ChatGPT, Claude, Copilot and Grok. The administration’s “Stargate Project” even explicitly seeks private data center finance for AI development. Energy generation may be a limiting growth factor but could still bode well for ABS investors given potential for rising rental premiums.

Notably, the development of China’s competitor model, DeepSeek⁶, raised questions on whether generative AI programs can run more efficiently than previously thought, negating some of the investment need around data centers and the energy to power them. If it is the case, we believe it would impact newer properties, particularly those in areas with questionable energy infrastructure. Our focus is therefore on well-established leases in areas with well-established infrastructure – particularly North Virginia, the undisputed “data center capital of the world”⁶.

Whole business securitizations – franchising fixed income cash flows

Whole business securitizations (WBS) collateralize all or almost all of a company’s or single business line’s cash-generating assets.

The most natural issuers have been large franchises, as the regular fees that franchisees pay their franchisor are the type of predictable, regular cashflows that fixed income investors value. Consequently, the most common issues have been fast-food industry giants such as Subway, Taco Bell, Wendy’s and Domino’s Pizza⁵.

America’s top three franchises, as ranked in the Entrepreneur Franchise 500 based on cost, size, growth, and brand, all have WBS outstanding. The current number two ranked franchise, Jersey Mike’s⁵, has wrestled significant market share from direct competitor Subway in recent years⁵. The company issued a potentially attractive WBS in December, backed by assets like franchisee fees and its US trademarks, and priced ~60bp wide to equivalently rated corporate bonds⁷. In our view it benefits from a strong debt metrics, a robust private equity sponsor, and the continued leadership of its decades-long-serving CEO.

WBS have expanded beyond traditional franchises to include diverse sectors such as gyms, childcare brands, and less conventional assets like media rights. A notable example is the SESAC⁵ deal from last August, which was backed by royalty payments on songs by renowned artists likes Bob Dylan, Adele and Neil Diamond.

Commercial real estate – Good investments in a beaten sector?

Commercial real estate has been a significant casualty of the pandemic, with office spaces particularly affected due to enduring remote working trends (Figure 5).

Figure 5: Remote working continues to inflict delinquencies on office deals⁸

Realized loan losses and distressed sales nonetheless remain relatively contained, partly given willingness from lenders to extend maturities. The market may have bottomed, but we see fundamentals and property valuations as challenged and the recovery may be a slow burn without a default cycle to reset the market. In the conduit CMBS market, relatively tight senior spreads require caution.

However, we see selective value in single-asset, single-borrower (SASB) CMBS, which we characterize as bifurcated between the “haves” and “have nots”. The highest tier office buildings saw 2.4% pa rental growth in H1 2024, but lower-tier rental growth declined 1.2%⁹. Caution is vital, but “Class A” “trophy” offices may be worth considering, such as the January 2025 deal secured against the “Spiral” in New York City’s Hudson Yards district. This deal potentially benefits from 84% of tenants rated investment grade with generally long-term leases. We believe the issuer may also benefit from a large sponsor and moderate leverage. The single-A rated tranches offered a ~90bp spread premium to similarly rated corporate bonds at issue¹⁰.

MBS may offer compelling spreads and mission bonds may pose an opportunity

Although many securitized opportunities exist outside the Agg, we also see significant potential within the $8tn agency residential MBS market which comprises over a quarter of the Agg.

MBS offers a historically compelling spread pick-up versus comparably rated corporates on a nominal (i.e. not option-adjusted) spread basis, including the excess spread that investors demand for prepayment and extension risks (Figure 6). We also anticipate an increase in foreign demand, particularly from Japanese banks seeking additional carry.

Figure 6: MBS offers historically compelling spreads versus comparably-rated corporate bonds¹⁰

Over the last year, a new sub-sector informally known as “mission bonds” emerged as a potentially attractive opportunity. Fannie Mae introduced a Mission Index in 2022, which scores bonds across three dimensions, offering higher scores for borrower traits such as low-income (particularly rural) and first-time homebuyers. It updated the framework last year and provided a “social bond” designation for pools that meet certain thresholds.

For investors, the key benefit of the Mission Index is enhanced transparency into mortgage bond collateral. Further, a key benefit of social (or “mission”) bonds is the greater expectation that the cohort will deliver slower prepayments through the Fed’s cutting cycle.

Fully unlocking the structured credit premium requires a specialist skillset

When investing in structured credit, especially when venturing outside the Agg, investors need access to credit specialist expertise. Each sector demands a unique skill set.

For example, investing in data center securities requires knowledge in real estate, power generation, cloud computing, and technology. WBS deals differ from other ABS deals in that the health and skill of the sponsor are crucial, given their management of franchisees and their cashflows.  

Insight’s dedicated global structured credit team invests across traditional securitized sectors and has been an early adopter of esoteric structured credit, not just in tradable securitizations but also the “clubby” private and less liquid esoteric market on behalf of our global institutional clients.

In our view, investors can add significant value by being intentional in their approach to ABS within their Core Plus strategies.