Rampant technicals push cash and CDS in different directions

Central bank interventions, primary market issuance and high yield defaults have conspired to create major distortions in credit performance, which sources say are ripe for opportunistic trading.

Dislocation in credit is evidenced by narrowing between high yield and investment grade CDS indices at the same time as HY bonds underperform IG bonds. In Europe, the iTraxx Crossover index has tracked stock market outperformance, but bond investors have cautiously sought issuance backed by the European Central Bank buying programme, driving IG spreads tighter.

“There is big interest playing the central bank trade and little trust in growth numbers,” says Alberto Gallo, portfolio manager of Algebris Investments’ Global Credit Opportunities fund. “But people are buying a losing trade. They are betting on central banks doing more, but will lose money over time with any small rise in inflation.”

The US market compression between CDX IG and CDX HY spreads is even more technical. It results from defaulting names exiting HY, but also a big gap opening in creditworthiness of IG names. “Dispersion has gone through the roof,” says one credit strategist at a US bank.

Compression and dispersion are interlinked topics, according to Pierre-Yves Bretonniere, head of relative value strategy at BNP Paribas. “There is less dispersion in CDX HY than in March because wide end names have left the index and the index quality is better now,” he says. “But in IG the widest names, where there is still demand for protection, have not defaulted, while the non-story single A to triple B rated names have rallied a lot. It keeps dispersion in IG high.”

Investors get creative with new ways to trade the curve

Credit index curve trading is gaining new features going into August, evidencing deeper liquidity for CDS strategies, but also that investors already have one eye on the upcoming September rolls.

Five to 10-year curve trading began to gain traction before the March sell-off, with dealers offering them as packages to ease bid/offer costs. Shorter duration curve flattener bets made money for some funds during the downturn as near term protection buying surged.

But with spreads having partially normalised in recent weeks, a developing trend has been the use of previous index series to express views on curves. These look to exploit lingering gaps between the series and their underlying constituents.

“Investors have sought ways to play the curve. One way is to buy protection on old series of iTraxx Europe five-year versus selling on-the-run five-year,” says Pierre-Yves Bretonniere, head of relative value strategy at BNP Paribas.

This adds value to a standard curve flattener trade as there is more skew on old series, he says — about 5 basis points on S32 and 6.5bp on S31, versus 4bp on S33. Investors have also been putting curve steepeners on five to 10-year iTraxx Europe, a position that usually performs with the roll. “It has performed better than IG, although there has only been 1bp of steepening so far,” says Bretonniere.

Direct lenders brace for requests to ignore covid quarters

Direct lenders will need to think about using different tracking mechanisms to measure a portfolio company’s performance going forward, as key metrics have been affected by covid-induced volatility, say market participants.

Several tracking mechanisms in private debt documents — for example, maintenance covenants — are based on ebitda. These are the last 12 months’ figures and therefore backward looking, meaning they could capture coronavirus-related shocks even after the market has moved on.

For a direct lender facing requests for covenant relief and assessing the medium-to-long-term covid-19 effects on new companies, these numbers may be critical in assessing a borrower’s future performance.

“If you are doing a new deal now and you’ve got the LTM, you know that the last two quarters would likely have been difficult and not representative of the normal run rate,” says one direct lender. “It’s inevitable you will get the question of ‘why don’t you insert one quarter from the previous year versus covid-19?’ It’s a bit like covid-mulligan,” he says.

But some direct lenders argue that now isn’t the time to address these issues. “The right thing is to defer those conversations to closer to when the company starts to recover,” says one lender. “The main aim for us is to ensure the survival of these companies.”

New funds move in as tranche trades take off

Synthetic structured credit funds are proving popular with investors amid a spike in index tranche trading. As previously reported, these positions will be targeted by two start-up London-based firms: BirchLane Capital and Palm Lane Partners.

BirchLane is led by Fajr Bouguettaya, the former head of credit correlation at JP Morgan, and has raised $200 million. Palm Lane’s chief investment officer is Fahad Roumani, who previously led the credit prop desk at JP Morgan. His firm is expected to launch imminently.

In the first half of 2020, index tranche volumes have reached about $175 billion compared to $250 billion in full year 2019. Stockholm’s Ymer, which launched a multi-strategy structured credit fund at the start of this year, bought the equity tranche of the iTraxx Main index in Q2, when this was trading at close to 50 points up front. This has tightened to 30.5 as goes to press.

Ymer partner Hubert Warzynski says that in contrast to the tranche market, CLO liquidity dried up in March and April. “If you had €500 million of dry powder you would have struggled to deploy in European CLOs as there were few b-wics.”

Flat Rock eyes interval fund conversion for private BDC

Flat Rock Capital Corporation, a private business development company managed by Flat Rock Global, has filed to convert to an interval fund, according to US regulatory filings. The BDC will merge into a new entity, subject to shareholder approval.

Sources say the firm wants to make its returns more easily available to investors and an interval fund conversion will allow shareholders to purchase the fund using a ticker rather than by signing a subscription agreement.

The Flat Rock fund invests in the first lien debt of US middle market companies with ebitda between $5 million and $75 million, as well as CLOs and other BDCs. It went into the crisis below 0.4 times debt-to-equity.

Separately, in March, New York-based Flat Rock launched a private fund for institutional investors investing in publicly traded BDCs named Flat Rock Credit Partners Fund.

“During times of stress, publicly traded BDCs tend to sell off at 50% book value,” says a source familiar with the matter.

The Flat Rock fund will run a concentrated portfolio of what it believes are the best publicly traded BDCs. Sources claim the fund has returned around double that of BDC indices with half the volatility. Officials at Flat Rock decline to comment.

Cut! Cineworld’s cancelled merger boosts CLO OCs

Investors in Cineworld’s $1.9 billion term loan breathed a sigh of relief in July after the UK cinema chain cancelled its merger with Canadian firm Cineplex, with holders repaid in full, according to market sources.

The loan was issued in February to finance the acquisition, but its price tumbled from par to the 60s after cinemas were forced to close to mitigate the coronavirus pandemic. The loan was downgraded to triple C shortly after.

The cancelled M&A transaction means lenders will be repaid their principal at par — giving CLOs that hold the loan some breathing room on their over-collateralisation tests. Sources say some CLOs would gain as much as 30 basis points towards their OC test, thanks to no longer holding a distressed triple C asset.

According to CLO-i, the largest CLO holders of Cineworld’s debt are GSO Capital Partners, Credit Suisse Asset Management and CIFC Asset Management, with over $100 million exposure each.

Triple A CLO investors advocate return to five-year reinvestment

As senior CLO spreads tighten across the globe, investors are pondering a return to pre-covid standard structures — but not everyone is in favour.

“I have seen growing appetite in the triple A community to do a longer reinvestment period of four to five years with a two-year non-call period, but managers and equity aren’t interested in issuing longer locked-in liabilities, given spreads are still historically wide,” says Scott Snell, portfolio manager at Tetragon Credit Partners. “Until spreads tighten a bit further, the 3-1 structure will likely be the most prevalent.”

The majority of new US CLOs are fully ramped in the covid era, as pre-covid hung warehouses are cleared. Investors say these deals are expected to perform better than their pre-covid cousins: they have less exposure to impacted businesses, and managers took advantage of lower dollar prices in the loan market with an eye toward a potential rally.

In the US, attention is turning to the reintroduction of high yield bonds to CLO portfolios following the Volcker rule revision, which becomes effective in October. Snell says many managers Tetragon speaks to are “excited” about adding 10% bond buckets to deals.

“Even though they might not use their buckets from the outset of a transaction, it helps to have the flexibility,” he says.