Structured credit markets are being affected by technical factors as investors confront modest new issuance, constrained dealer inventory, and lower liquidity than the norm in recent years. Price volatility has been exacerbated by uncertainty over risk retention rules, forced selling by institutional funds facing redemption pressure, and concerns about broader global economic trends.

Consolidation in the investment manager ranks is likely, as smaller firms with less dependable capital bases struggle to meet new rules designed to better align the interests of managers and their clients. The regulatory pendulum has swung aggressively against originators of securitizations. Oversight from government agencies has improved the underwriting, reporting, and monitoring of the assets in current securitizations. But the improvement has come with a cost to managers. By the end of 2016, securitization managers will be required to retain 5% of the equity or the same percentage of the entire capital stack in each issue. Smaller managers without enough capital to meet the contribution requirements will sell their firms or exit the business. New issuance of collateralized loan obligations (CLOs), for example, has slowed dramatically this year as managers position to be risk retention–compliant by year end. Larger firms with more capital will control greater market share going forward.

At the same time, broker-dealers have contracted their market-making activities in structured credit. They’re maintaining limited inventories of securities due to the high capital charges under the Dodd-Frank Wall Street Reform Act. As a result, bid/ask spreads can be wide, and meaningful parts of the market do not trade consistently. The liquidity constraints and spread widening since third quarter 2015 have negatively affected performance, and investors have increased redemptions from dedicated structured credit funds and some multi-strategy funds, further aggravating volatility. To address the attendant risks, managers are reducing the size of their trading blocks, stretching out timelines to build or exit positions, and holding more cash.

However, the exodus of large international banks and some traditional holders of structured credit assets has allowed managers more flexibility in constructing unique portfolios. Most investors access this sector through vehicles focused on either CLOs, residential mortgage–backed securities (RMBS), commercial mortgage–backed securities (CMBS), or asset-backed securities (ABS), which include student loans, credit card receivables, auto loans, equipment leases, and small business loans. Investors can now own some or all of these assets with thousands of underlying securities in a single fund, leading to distinct strategies that do not overlap with those of other managers and that can be uncorrelated to other securities markets. Today, most products come in a hedge fund format with periodic liquidity, but this is changing. More private investment funds have emerged to better match assets and liabilities in an environment of constricted liquidity. Fund offerings can also be regional or global and levered or unlevered.

While securitized assets gained infamy during the global financial crisis for their extreme volatility, the post-crisis era has been marked by new legislation designed to lower systemic risk and distribute responsibility for performance among managers, rating agencies, and investors. Pockets of opportunity will continue to appear in these markets, but windows can close quickly, so investors interested in this space should partner with managers that have a diversified strategy, limited leverage, and a stable capital base.

Myles Gilbert is a Managing Director on the Cambridge Associates Global Investment Research team.