But risk-taking remains subdued

Structured credit products suffered greatly during the recession of 2008 as problems with subprime real estate first spread to various types of mortgage-backed securities. This was followed by other investment vehicles in the securitization world, including collateralized loan obligations. Although many facets of the real estate market in the U.S. continue to deteriorate, structured products have come back to life.

CMBS 2.0: Revival of a market

As the CMBS market made its comeback in the past 12 months, issuers and underwriters have made sure that the structures of transactions are more conservative than at the top of the market in 2006 and 2007, for example, drastically reducing the leverage of deals as well as the power of special servicers in restructuring. As a result, issuance soared. From virtually no issuance in 2009, roughly $10 billion worth of new CMBS were issued in 2010 and predictions for 2011 called for $25 billion to $40 billion in new CMBS.

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The CMBS market certainly looked promising at the beginning of the year but issuance slowed down mid-year and stood at roughly $22 billion as of July. The slowdown in issuance was due to several factors:

In July, Standard & Poor's withdrew its rating on a CMBS issue after it identified an error in its methodology, causing the issue to be pulled out of the market and issuance to come to a halt. To make matters worse, concurrent with the S&P announcement, worries about the U.S. economic growth and the possibility of a double-dip recession intensified and spreads started to widen. Issuance of CMBS has since resumed but remains subdued and most importantly has transitioned to the public market, where investors require more collateral - 30% as opposed to 20% with private placement deals -- to make up for the added risk, explains Colleen Denzler, Senior Vice President and Head of Fixed Income Strategy at Janus Capital Group.

"Since the 2008 crisis, most CMBS issues were in the 144A private placement market where issuers can disclose a greater level of information relative to public markets. With issuance shifting from private to public placements, recent deals have less information and thus are less valued," said Denzler. "In an uncertain environment, investors want even more to be able to analyze the risk they're taking."

As a result, investors should focus on the highest tranches of CMBS deals.

"CMBS really have exhibited extreme volatility," said Steven Huber, Portfolio Manager in the Fixed Income Group at T. Rowe Price. "You’re currently getting decent value in the higher-quality tranches at the very top of the capital structure. But even there, you still can have significant spread volatility."

"Our preference is for up-in-capital-structure CMBS exposures," which provides a necessary margin of safety, concurred Rich Talmadge, Head of Structured Credit at Cutwater Asset Management. He noted that new issue AAA classes are demonstrating good relative value since they have sold off from their highs back in early May. Further, Cutwater favors super-senior CMBS over real estate investment trusts. "Quite simply, CMBS spreads, even at the 30% credit enhanced super-senior level, have been oversold in reaction to macro market technicals whereas REIT spreads have remained tight to corporate spreads, even beyond what the stronger property and sponsor quality in REITs might warrant," Talmadge added.

Agencies MBS and policy risk

Still in the real estate world, agencies MBS have been attractive but not risk-free. Huber reckons the sector presents opportunities for defensive purposes. "Valuations are attractive at wide spreads," he said, adding that "the risk currently is more on the policy side."

Denzler explains that the Federal Reserve currently owns a big chunk of agencies mortgages with very low rates. As a huge refinancing wave approaches, a lot of MBS will get called, providing cash to investors. "They can buy new mortgages but the new issues are 30 years with higher durations," she said. "You’re getting short bonds called away from you and being replaced by longerduration bonds. We are so close to zero that even if they rally, it's not a very good trade off."

Safety in ABS

For its part, the asset-backed securities market remains well structured and safe, although returns are low. The safety is due to a good diversity in the underlying collateral, a strong subordination and great transparency of transactions.

"There’s been low risk, low volatility in ABS," said Huber. "Spreads are much lower than other securitized sectors and there’s not a lot of juice. It’s a relatively safe sector, but with low return expectations."

Stick to the top with CLOs

During the 2008 crisis, CLOs, a form of collateralized debt obligations made of high-yield leveraged loans sliced into securities, suffered from the general market sell-off and became illiquid at times. Issuance, which had reached a peak in 2007 of $91.1 billion, froze, with only $3.4 billion of CLOs issued in 2010, according to Bloomberg data. The CLO market has slowly returned with $7 billion in new deals as of the end of August, and estimates by J.P. Morgan of $10 billion to $15 billion for the year. Still, the space is victim to periodic bouts of illiquidity and price volatility, which investors have to be willing to weather.

With that in mind, experts recommend to focus on investments at the top of the CLO capital structure as they provide access to diversified pools of senior secured leveraged loans while being well-protected against future economic downturns from the credit enhancement provided by more subordinated tranches and by other structural protections, according to Jason Cameron, Senior Portfolio Manager for CDOs and CLOs at Cutwater.

"At current valuations these tranches are providing investors with attractive risk-adjusted returns that are defensive against interest rate rises since CLO liabilities generally are issued with floating rate coupons benchmarked to London interbank offered rate," he said. "As an asset class, U.S. senior secured leveraged loans have exhibited stable fundamental values through time due to the value of their collateral and seniority versus other creditors. And CLOs have proven to be relatively stable and resilient in part due to the underlying value of the loan assets backing them."

He added that CLOs have been the only CDO subsector that has seen a return of a primary market postcrisis. Although risky and sometimes lacking liquidity, structured products have become a must in the portfolios of investors wanting to emphasize diversification.