CLO funds make best of a bad situation

The fund is a CLO risk retention vehicle for Fair Oaks-managed CLOs, with the manager known for its high-rated and low-spread portfolios. Fair Oaks founder Miguel Ramos Fuentenebro says CLO investing only makes sense if you keep defaults under control.

“We have had zero exposure to retail since we launched our platform in 2019,” he says. “This imposes a trade-off versus diversification, potentially reducing the leverage for the CLO equity, but we took the view this was the correct strategy.”

The London-headquartered manager had another CLO fund with positive performance last year: Fair Oaks Master Credit III. It invests in control CLO equity across the board, including US, Europe, third-party CLOs and Fair Oaks-managed CLOs. It can also opportunistically invest in CLO debt tranches. And Fair Oaks has made full use of that flexibility.

“The portfolio started reducing its CLO equity exposure in late 2019, which placed it in a very good position to take advantage of the market dislocation in 2020. By the middle of 2020, the portfolio was roughly half CLO debt tranches,” says Fuentenebro.

He says Fair Oaks hasn’t invested in equity tranches over the past two years, as the cost of CLO funding increased. In September, following the liability-driven investment crisis, the firm was looking at opportunities in CLO single and double B tranches, across primary and secondary.

“There is a material difference between a CLO portfolio with a 340 basis points weighted average spread and one at 360bp. For the latter CLO, cash distributions will be higher, but for 20bp extra spread you are taking on a lot of extra risk.”

Bates says tight CLO pricing was important last year. “A lot of our managers might be deemed boring, but they got strong execution on their CLO liabilities.”

Flat Rock is an advocate of middle-market CLOs, and Bates says these types of deals performed well as the underlying middle-market loans exhibited more price resiliency than broadly syndicated loans.

Olivier Gozlan, portfolio manager at Crystal Funds, attributes outperformance in his fund to four factors: resets, trading amid stronger markets, equity distributions and buying in a “local bottom (price-wise)”.

“After the Omicron variant in January and February 2022, and before the war in Ukraine, we had a fair amount of resets. Those resets, which were some of our largest positions in the portfolio, not only created pull to par effect, but also gave us extra cash to reinvest,” he says.

Using that cash, Gozlan says buying in a “local bottom” contributed to performance. “We were decently axed in primary and secondary markets from May to July 2022,” he says. “Back then, we could source European CLO single Bs at 1,500bp, and US and European CLO double B in the 1,000bp area.”

Later in the year, Gozlan says the firm was able to offload equity positions when the market became stronger.

Rajay Bagaria, chief investment officer, says his firm specialises in under-followed, mostly private issuers of high yield bonds and leveraged loans.

In 2022, when yields hit historic tights, Wasserstein shied away from high yield bonds and repositioned the book into leveraged loans, which it expected would outperform due to the rate hike cycle. As this played out and HY underperformed, the fund opportunistically bought bonds mid-year because HY bond prices reached lows only surpassed by the 2008 financial crisis and covid sell-offs.

“Some of our most successful trades targeted 2021 LBO debt, which had liquidity, runway and significant sponsor capital at risk,” says Bagaria. “The long duration of this debt, along with the low coupons representative of 2021 new issues, caused prices to decline 25-35 points from levels seen 12 months prior. We were obtaining 13% cash returns with roughly 20% unlevered yields for debt that was senior to LBO equity and had credit downside protection.”

David Weeks, chief investment officer at LMCG Investments, attributes the sound performance of its relative value credit strategy to a mix of rising rates, wide credit spreads, moderate volatility in corporate credit, low defaults and price inefficiency in mortgage credit. “Last year, relative value opportunities opened in seasoned mortgage credit bonds and delta-hedged junior tranches of credit indices,” he says. “Synthetic corporate credit tranches in Europe were particularly interesting, given market volatility due to the war in Ukraine.” Andreas Eckner, portfolio manager at LMCG, says that, in 2022, the housing market took the brunt of the Federal Reserve’s interest rate increases.