Global credit funds & CLO's
April 2020
| Issue 222
Published in London & New York.
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News in brief
April 2020 | Issue 222
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High yield index widening drives equity tranche trades
The blow-out in corporate credit spreads is creating opportunities in the index tranche market.
In March, CDX NA HY has gone from 371 to 866 basis points, and sources say credit derivative specialists are going long the equity tranche, delta-hedging against the index.
“It’s a cheap way to buy gamma,” says a New York-based trader.
Credit spreads had tightened to post-crisis tights at the start of this year. The subsequent sell off has caused sought-after volatility, but its speed has meant that putting on other trades — such as CSOs — has been difficult.
“The index tranche market is much more liquid and provides a strong alternative to CSOs,” says a credit portfolio manager.
SME CLO features PDL mechanism
Details of the groundbreaking Alhambra SME Funding 2019-1 — the first 2.0 CLO backed by loans to small and midsized enterprises — were revealed at the Direct Lending Forum jointly hosted by Creditflux and Debtwire last month. The transaction, which priced in November, features investment from the European Investment Bank, but this comes at a cost.
“There was a pretty defensive PDL [principal deficiency ledger] mechanism to protect the EIB tranche,” said Pablo Perez, structurer at JP Morgan, which was co-arranger on the deal. A PDL facility diverts cashflows in the event that underlying loans suffer impairment.
An audience member queried the absence of any single A or triple B rated debt in Alhambra, to which Perez pointed out that the enlarged EIB tranche (rated double B), effectively absorbed single As and triple Bs.
11 other investors signed up to the deal, he said. Alhambra 2019-1 was not considered an eligible asset by the European Central Bank (therefore it isn’t acceptable as collateral by European central banks). This meant the transaction did not appeal to traditional ABS investors, but was sold to asset managers with CLO experience.
SMEs are vulnerable to coronavirus-induced lockdowns across Europe (at the time of the conference, 10 March, most countries had not taken such measures).
“11 other investors have signed up”
Pablo Perez,
Structurer | JP Morgan
Lenders look at MAC clauses amid revolver demand
A plethora of revolver draws has swept through the corporate credit markets. While banks and asset managers have so far shown the capacity to meet their unfunded commitments, the material adverse change (MAC) clause in credit agreements could allow them to pushback on borrowers.
“A borrower must make representations and warranties that there hasn’t been a material adverse change,” says Alyson Gal, partner at Ropes & Gray and co-head of the firm’s direct lending practice. “The borrower can make that representation and lenders can question it.”
Beyond any funding issues that might arise for lenders should a borrower request a revolver draw, a revolver draw also has implications for the rest of a company’s creditors —namely, whether they might benefit from a springing covenant.
A springing covenant is dormant until a draw on revolver commitment activates it. Of the $350 billion in public term loans analysed by Xtract Research, a sister publication of Creditflux, roughly $65 billion have a springing covenant.
“The borrower can make a representation and lenders can question it”
Alyson Gal,
Partner | Ropes & Gray
Empty rooms test CRE CLOs linked to lodging
After a banner year for CRE CLOs, the asset class seems uniquely exposed to the coronavirus — particularly for loan collateral tied to lodging, according to research from Kroll Bond Rating Agency.
A key metric to assess the asset class — revenue per available room — fell by more than 30% year over year during the first week of March, with New York and San Francisco hit especially hard, according to Kroll.
Most CRE CLO loan portfolios consist of transitional loans that have shorter durations than the corporate loans that back CLOs and mortgages that back CMBS. There are $2.3 billion in lodging loans mixed into 30 of Kroll’s 36 rated CRE CLOs.
Deals with the largest lodging exposure belong to Shelter Growth Capital Partners. SGCP 2019-FL2 and SGCP 2018-FL1 have loan portfolios with 35% and 29% lodging exposure, respectively.
‘Hoard credit’ says PM as markets swing
As Creditflux went to press, the covid-19 death toll in Italy surged by 700 after two days of slowing, and the US congress agreed a $2 trillion stimulus package. Both events point to rising systemic risk for financial markets and societies in the month ahead.
This should put sovereign CDS in focus, yet Italy’s five-year contract is back at 180bp, according to IHS Markit, some 86bp inside its 17 March local wide point. US CDS offers only 21.5bp, having slipped past Germany as the tightest G7 name.
There has been huge dislocation between companies, sectors, geographies, tenors and asset classes, raising the question of whether greater discernment or discord will prevail as April unfolds.
US versus European risk is a case in point. On 20 March, markets closed with a 33bp differential between iTraxx Europe, at 117.5bp, and CDX IG, at 150.75bp — influenced in part by the slump of oil to below $30 a barrel and CDX IG’s greater exposure. Yet during these early days of the crisis CDX IG has also traded inside Europe, and at press time just 7bp stood between them.
Stocks faired better than credit in early March, but that picture has reversed. Chris Bowie, portfolio manager at TwentyFour Asset Management, suggests the US Federal Reserve’s unlimited QE will protect coupon and principal payments, but not dividends.
In a recent note he says regulators will demand companies have “higher liquidity buffers, less operational leverage and ultimately more utility-like cash flows to investors” just as they did for banks after 2008-2009.
“Investors should be hoarding credit like they’re hoarding toilet rolls,” he concludes.
Investors watch Libor amid inter-bank liquidity concerns
After a freefall to 74 basis points on 12 March, CLO managers found some relief in watching Libor rise to 120bp during the second part of the month. The bounce avoided the 0% Libor floor triggers that are present in 60% of US loans and the 1% floors that appear in another 33%.
But Libor’s rise is symptomatic of a larger interbank liquidity concern that the US Federal Reserve is trying to combat. Whether Libor falls again in April after money market funds assess the damage from the coronavirus capitulation will be something to watch, says a primary dealer.
Money market funds and CLOs are not often mentioned in the same sentence. But in times of distress, systemic action from central banks reveals how many markets intertwine. For CLOs, a healthy money market in the US means that banks have competition in overnight lending.
“Money market funds are still in liquidity-raising mode for pure cash,” says the primary dealer. “And they are the main short-term liquidity providers for banks. Once they went into liquidity-raising mode, that made banks compete with each other. And that drove up Libor.”
The Federal Reserve is attempting to alleviate money market liquidity strains by introducing the Money Market Mutual Fund Liquidity Facility (MMLF). Among other things, the facility will allow financial institutions to buy assets from money market mutual funds by waiving any effect these purchases might have on regulatory capital.
This will relieve some stress for money market funds, says the primary dealer. But it will be weeks before the Fed’s actions have any effect on money market liquidity, their desire to lend to banks and whether Libor stabilises above 1%.
CDS show the way as prices move and volumes surge
CDS volumes provide an eye-opening view of how the asset class has grown in prominence during the coronavirus pandemic, with index trading near doubling year-to-date on 2019, even as secondary bond markets hit lockdown.
Wild oscillations of CDS provided the first signals of covid-19 related global credit volatility. But the extent to which CDS volumes have increased since suggests market participants have variously positioned using them, got caught in painful trades, and scrambled to find hedges.
Some $3.39 trillion notional of CDS contracts traded by 20 March, according to Isda SwapsInfo, up from $2.08 trillion at the same point last year. This is a big turnaround from January, when CDS volumes were way down on 2019.
No doubt the March index roll and options expiry drove an uptick, but mainly because of huge one-day moves in the run-up to those events. According to bankers and investors, swathes of investors were wrong-footed on more than one occasion before the roll, while options trading became a lottery of widely dispersed strike levels. Five- to 10-year index curve steepener trades came unstuck by flattening between the tenors, particularly in CDX IG.
Additional trading looks to have come from correlation traders buying CDX and iTraxx equity tranches delta-hedged against the index to express a pure view on correlation.
CDS notional trading
Managed accounts pose flexibility check for direct lenders
Direct lenders are closely analysing portfolio companies hit by coronavirus volatility for signs of financial stress, ready to inject capital and extend flexibility to companies where needed. But sources say some have been restrained by separately managed accounts with limited flexibility.
Managers and investors alike are wishing there was a bit more flexibility, says Jessica O’Mary, partner and credit funds leader at Ropes & Gray.
“In some SMAs the manager has been restricted from taking actions that require a quick response but that also need the consent of the investors,” she says.
“Investors have asked for consent rights, and now they have to be available to exercise them quickly. When requesting these rights, no one was thinking that people would not be available and that they wouldn’t be able to get a physical signature or business would be disrupted on the investor-side.”
If volatility continues, companies could face cash flow issues. Direct lenders are often the only provider of capital to lower middle-market companies, so it is up to them to provide that capital and support the company, says one New York-based placement agent.
“The benefit of having a direct lending partner is that they are not going to put the company into administration and will work through the situation.”
A direct lender adds: “If we are in senior secured positions with subordinated capital, we can get paid for the incremental risk if we invest additional capital to support a company facing a liquidity crunch through the slowdown. This improves positioning for when the economy recovers.”
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