Structured finance covers a broad range of financial products designed to package assets, cash flows or investment exposures into structures with defined risk and return characteristics.
Unlike a conventional share or corporate bond, where the investor’s return is generally linked directly to one company or asset, structured finance can combine multiple financial instruments or assets into a single investment structure.
Structured products are one example. They are generally pre-packaged investments combining instruments such as bonds and derivatives to create a particular payoff. The structure can be designed around a specific market view, income requirement, level of downside protection or exposure to an underlying asset.
The underlying exposure can vary considerably. Structured products may be linked to equities, indices, currencies, commodities, interest rates or other assets. The terms determine how the investor receives returns and what happens under different market conditions.
For example, a structured product may provide a defined income payment provided an underlying asset remains above a specified level. Another structure may offer some protection against losses while limiting the potential upside. Others can be designed to provide leveraged or conditional exposure to a particular market.
This flexibility is one of the main reasons structured products are used by professional investors. Instead of simply buying an underlying asset, the investor can select a structure that reflects a particular risk and return objective.
However, the additional flexibility also means that investors need to understand the terms of the product. Maturity, trigger levels, fees, potential returns, downside exposure, liquidity and the creditworthiness of the issuer can all affect the outcome.
Structured finance also includes securitised credit products such as collateralised loan obligations, or CLOs. These have a different structure from many of the structured products used to gain exposure to equities or other market assets.
A CLO is generally backed by a portfolio of corporate loans, predominantly leveraged loans. The loans are held within a special purpose vehicle, which raises funding by issuing different classes of debt and equity securities.
The capital structure is divided into tranches. Senior tranches have the highest priority for receiving interest and principal payments and therefore generally carry lower risk and lower returns. Junior tranches sit further down the payment structure and take losses earlier, but can offer higher potential returns.
This creates a payment waterfall. Cash generated by the underlying loan portfolio is distributed according to a predetermined order, with senior investors receiving payments before investors in lower-ranking tranches.
The same principle applies when losses occur, but in reverse. Losses are generally absorbed first by the equity and junior portions of the structure before affecting senior debt tranches.
CLOs are also actively managed. A CLO manager can buy and sell loans within the portfolio during the permitted investment period, allowing the portfolio to respond to changes in credit quality, market conditions and available investment opportunities.
The underlying loans are typically made to companies with higher levels of debt or below-investment-grade credit characteristics. This means the performance of a CLO ultimately depends on the ability of those companies to meet their debt obligations.
The different layers of a CLO allow investors to choose different levels of exposure to that credit risk. A senior tranche may appeal to an investor seeking a higher level of structural protection, while a lower-ranking tranche can provide greater potential income in exchange for greater exposure to losses.
CLOs should also be distinguished from the mortgage-related structured products that were central to the financial crisis of 2008. Although both involve securitisation and different layers of risk, modern CLOs are generally backed by diversified portfolios of corporate loans and are actively managed.
The wider structured finance sector therefore includes products with very different characteristics. A structured note linked to an equity index and a CLO backed by corporate loans may both fall under the broad structured finance umbrella, but their underlying assets, risks and payment mechanisms are different.
Volta Finance Ltd (LON:VTA) is a closed-ended limited liability company registered in Guernsey. Volta’s investment objectives are to seek to preserve capital across the credit cycle and to provide a stable stream of income to its Shareholders through dividends that it expects to distribute on a quarterly basis.
