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Global credit funds & CLO's
April 2022 | Issue 244
Published in London & New York.
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April 2022 | Issue 244
Analysis
CLOs
Arb work pays off
Charlie Dinning
Data journalist
With day-one arbitrage alone delivering projected CLO cash-on-cash returns of 20-25%, 2021 may have been the best year ever for equity investors — at least until CLO spreads began to widen
As CLO managers say: ‘The arb is always attractive.’” Jason Friedman, global head of business development and strategy at Marathon Asset Management, made this quip at the Creditflux CLO Investor Summit last month. But in 2021, it rang true.
CLO day-one arbitrage levels in 2021 were some of the best ever, sources say. 2018 was also a bumper year for CLOs, but one market participant says times have not been as good for equity investors since 2012.
While managers are incentivised to call the arb good, equity investors are more selective. In fact, the most common refrain among investors has been: “The arb is challenging.” But 2021 changed that.
Christian Pellegrino, head of CLOs and partner at European CLO investor III Capital Management, says his firm models 20-25% cash-on-cash returns when investing in a new issue CLO. Last year, it could get there from arbitrage alone.
“We still believe that day-one arbitrage is important,” he says. “It doesn’t always mean the investment will work out, but it puts you in a position where you’re starting ahead.”
The difference between CLO assets and liabilities has returned to the fore after 2020 saw arbitrage levels crater, causing CLO managers to turn to short-dated CLOs with a one-year call-lock.
2020 CLOs were not economic on a spread arbitrage basis, but by buying heavily discounted loans, managers compensated with price arbitrage, sources say.
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US CLO day-one arbitrage 2021: WAS (%) vs funding cost (%)
The arb improved over 2021
CLOs that went effective in the first quarter of 2021 had the lowest average day-one arbitrage of the year, as the majority of these were priced in the last quarter of 2020. US CLOs averaged 191 basis points of day-one arbitrage, while European CLOs averaged 188bp.
Despite these being the lowest average figures of the year, the average for US CLOs was in line with 2018’s best quarter of 194bp. And for European CLOs, it almost matched the first quarter of 2019 when the average was 192bp (European CLOs take longer on average to go effective, with almost all of the Q1 2019 deals pricing in the second half of 2018.)
272bp
CBAM 2021-14 had the highest day-one arb in 2021
After the first quarter, both US and European CLO day-one arbitrage stayed steady for the rest of the year. In quarters two, three and four, US CLOs averaged 218bp of arbitrage at their effective dates (or nearest reports to those dates). European CLOs averaged 200bp, 201bp and 199bp in those quarters.
Sources say the biggest driving force behind the good levels of arbitrage was the dramatic tightening of triple A spreads after CLOs weathered a volatile 2020.
227bp
Napier Park’s average European CLO day-one arb for 2021
US CLOs with at least 4.5 years of reinvestment that priced in the last quarter of 2020 had an average triple A spread of 141.2bp over Libor. But these dropped significantly come the new year, with US CLO triple As in Q1 2021 averaging 115.3bp for a 18.3% decrease in triple A spreads. This led to US CLO funding costs falling.
US CLOs that went effective in Q1 had an average cost of debt of 187.4bp, compared to 165.2bp in Q2, which produced the lowest funding costs for US CLOs last year.
European CLOs with at least three years of reinvestment tightened even more than their US counterparts. Triple A spreads went from 110.7bp in Q4 2020 to 82.9bp in Q1 2021, a 25.1% decrease. But due to the longer period between pricing and effective date for European CLOs, Q3 was the tightest quarter for European CLOs, with the average cost of debt coming in at 173.7bp — a 24bp drop from Q1.
“A wider triple A tranche with fee concessions is an attractive trade”
Christian Pellegrino, Head of CLOs and partner | III Capital Management
However, spreads did widen back out throughout the course of the year, which caused arbitrage constraints, according to market sources. US CLO triple A tranches that priced in Q3 2021 paid, on average, 118.2bp, a 3.5bp rise from Q1. European CLO triple A notes gapped out to 100bp, a 17.1bp increase from Q1.
Boca Raton-based Pellegrino says: “When the arbitrage worsens, you need to start receiving fee concessions from managers and underwriters to make the economics work. For us, a wider triple A tranche coming with fee concessions is a more attractive trade than buying a CLO with a tight 80bp triple A tranche, as you’re closer to being in the money on a refi or reset when the non-call ends.”
“If the arb is worse, you need a longer warehouse period”
Lauren Basmadjian, Head of US loans and structured credit | Carlyle Group
But there are other options available for CLO managers, says Lauren Basmadjian, co-head of liquid credit and head of US loans and structured credit at Carlyle Group. “In environments where the arb is a little worse,” she says, “you need a longer warehouse period as you are then going to create assets at a cheaper price because there is more new issuance that you are able to include.” And there was a lot of loan choice available in 2021.
M&A and LBO volumes boost CLOs
$910.4 million of institutional US loans priced in 2021 due to high M&A and LBO numbers, which made it easy for CLOs to ramp up, according to sources. The loan market also benefited CLOs through Libor floors, which increased the amount assets paid, while the expected loan refinancing wave did not materialise as the market did not go above par for much of the year.
Carlyle had the third-best overall day-one arbitrage among US CLO managers in 2021. It averaged 243.7bp of arbitrage across an astonishing nine deals. First Eagle pipped it to second with 244.2bp of arb across two CLOs. And CBAM 2021-14 had the highest day-one arbitrage for CLOs last year, recording 271.8bp, in what was CBAM’s only eligible CLO. Carlyle has since bought CBAM from Eldridge Industries.
European CLO day-one arbitrage: WAS (%) vs funding cost (%)
Napier Park is top in Europe
Napier Park Global Capital topped the European CLO managers day-one arb charts. It delivered an average of 226.8bp across its two CLOs. Napier Park has also recently been acquired, with First Eagle swooping for the business last month. PGIM was second in Europe with its sole deal, Dryden 88 going effective with 224.8bp of day-one arbitrage. Spire Partners rounded out the top three at 222.1bp from two CLOs.
Methodology
- Multiple of money was calculated by dividing aggregate equity payments to date by the par size of the subordinated notes.
- Arbitrage was calculated based on the difference between a CLO’s cost of financing and asset-weighted average spread. Weighted average spread was taken from the effective date report, or the nearest available trustee report to the CLO’s effective date.
- For funding costs, fixed rated tranches were converted to floating rates based on floating rate pari passu tranches. For non-pari passu tranches, the Libor rate when the deal went effective was taken away from the tranche’s fixed rate.
- Data was sourced from CLO-i and Moody’s Analytics and includes only US and European BSL CLOs that went effective in 2021 with reinvestment periods of at least one year. Triple C-flex, bond-flex and ‘fat triple B’ CLOs were excluded.
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