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July 2022 | Issue 247
Analysis
CLOs
Can someone call the triple A? We’ve stalled
Charlie Dinning
Data journalist
Tanvi Gupta
Head of data journalism
CLO issuers are in need of AAA roadside assistance. Despite the emergence of new buyers, a lack of senior CLO investors — particularly US banks — has brought the primary market to a halt
Last year, US banks increased their CLO triple A exposure by $72 billion, while the global CLO triple A market increased by $86 billion, according to Bank of America research. These figures suggest US banks accounted for 84% of triple A paper in 2021 — and highlights their importance in the CLO market.
In 2022, US banks have held back from the primary market. This has led to inconsistent pricing and exposed the lack of depth in the investor base.
Nevertheless, a US CLO arranger says the primary market is now in better shape than it was a month ago because the triple A investor base has grown to 30-35 names. Japanese banks, such as Norinchukin, Japan Post and Mitsubishi UFJ Trust & Banking, along with other regional banks are the most prominent, say market sources. TD Bank and Calpers have also increased their appetite for CLO paper this year. Calpers hired former Bank of America CLO trader Justina Wang late last year.
In Europe the picture is less rosy, as global triple A investors continue to favour the US. One such investor pointed out that European triple As have to be wide of US CLOs for the investment to be compelling. “We don’t get the benefit of cross currency swaps so we look at the spread versus spread basis and, for us, European triple As are too tight versus the US.”
S&P/LSTA loan index: US & Europe
Source: S&P/LSTA
Why are US banks pulling back?
“Expectations of quantitative tightening are one factor stopping US banks from buying CLO triple As,” says Armen Panossian, head of performing credit at Oaktree. This is why the market has moved sharply to 180-190bp and beyond, he adds.
Hold-to-maturity investments are another factor. BofA research highlights that out of $170 billion of CLO exposure held by US banks as of the end of 2021, the vast majority is held to maturity, with only $15 billion available for sale.
A CLO buyer at a US bank says the reason they are absent from the CLO market has nothing to do with the relative value proposition. Rather, they’ve reached the limit of CLO exposure in their portfolio. “Our portfolio is designed as hold to maturity, so we can’t sell in secondary. On top of that, nothing is refinancing/resetting. But the limits are not set in stone and can change at quarter end,” says the portfolio manager.
A few US banks have been active in secondary this year, despite the limitation that they cannot buy bonds benchmarked to Libor. “Triple A CLOs are at the same or wider spreads in the secondary market and are available at steep discounts,” says an investor.
“Expectations of quantitative tightening are stopping US banks buying CLO triple As”
Armen Panossian, Head of performing credit | Oaktree
In Europe, the CLO triple A investor base is so thin the market is effectively at a standstill. “Usually, Barcelona [ABS IMN conference] is an opportunity to talk up the market and walk away feeling more positive, but it wasn’t the case this year,” says Andrew Lennox, senior portfolio manager at Federate Hermes. “So we haven’t seen the flurry of European new issues that are typically announced in this period.”
But there are hopeful signs. As Creditflux goes to press, Barings, Blackstone and Investcorp are aiming to break through by marketing European CLOs with long reinvestment periods. Barings’ triple As are guided at 160-170 basis points, while Blackstone is at 155bp, say market sources.
In the US, 13 CLOs are in the marketing stage, with a further 20-25 CLOs at various different stages of launching, add sources.
Investors look to lock in wide spreads
The lack of buyers for CLO triple As has caused spreads to blow out at the top of the capital structure, with US CLOs now paying above 200bp over Sofr for three-year transactions — levels not seen since the covid crisis in 2020.
Back then, the CLO market quickly switched to three-year reinvestment period CLOs with a one-year call-lock, but investors have been reluctant to do so this time around. Instead, they prefer to lock in wide spreads with a market standard 5/2 structure, causing the curve to invert as CLO managers are forced to offer a premium for short-dated transactions. Three-year US CLO triple A coupons are 195.6bp, versus 172.3bp for a five-year deal.
In Europe, Permira’s Providus CLO VII was the sole CLO to price in June. It has a triple A spread of 140bp and five years of reinvestment, which is a sharp jump from the average of 115.8bp in May.
One triple A investor stated their level is 180-190bp for a 5/2 structure in primary, but they will target only top tier CLO managers and have 13 on their approved list. Another global triple A investor, which has been inactive in Europe recently, claims that levels are too tight for them to return to European CLOs.
But CLO triple As at these wides do not make sense considering where lower mezz tranches are pricing, according to Christian Pellegrino, head of CLOs and partner at III Capital Management. “When the CLO market widens due to growth concerns, typically the junior tranches widen more than the senior tranches on a relative basis as higher defaults are priced in. But that didn’t happen, which suggests a liquidity issue and means that either triple As are too wide, or lower mezz is too tight.”
In June, US CLO double B spreads on five-year CLOs have widened to an average of 806.7bp from 755.5bp in May, an increase of 6.7%. In the same period, triple A spreads have blown out 13.3% to 172.3bp.
Insurers help keep lid on triple Bs
In the secondary market, US CLO triple Bs have been especially resistant, sources say, with tier one and two paper trading around 400bp. But this is partly because of who is buying those bonds.
For example, insurance companies operate in this space and have a small, approved manager list, which makes the paper more expensive. One investor states that “rigid mandates cause mispricings”.
This is part of the reason that European mezz is more attractive than its US counterpart, sources say. One European investor said that “lower mezz feels like an unloved trade, but there’s a lot of ‘yieldy’ opportunities”.
“Going forward, you’re going to have supply overhang from split warehouses”
Edwin Wilches, Co-head of securitised products | PGIM
Another CLO investor prefers European CLO mezz as it is cheaper and safer than a US equivalent, thanks to its higher levels of par subordination and greater excess spread. The severe drop in the European loan index, which went below 90 last week, has also caused a “dramatic repricing” in the market. This has presented buyers with opportunities, sources say.
One European investor says European double Bs shot out from the 700s to the 900s in a matter of days. European CLO double B bonds are now trading between 80-85 in price terms, with a 900-1,000 DM. In contrast, US double Bs are trading closer to 90 cents and at 850-950bp.
Another factor in the secondary market’s favour is how orderly sellers and buyers have been, sources say. It is a fair, two-way market, and sellers have not been bringing bonds to the market as pricing exercises, a practice which was rife in 2020.
European CLO triple A benchmark (bp)*
US CLO triple A coupon (bp)*
3 month US CLO term curve
Source for all charts: CLO-i
* 3 year reinvestment CLOs included for 2020 and 2022.
Splitting warehouses helps spread risk
There are more than 200 warehouses in the US and around 75 in Europe, say market sources. And while this is a high number in an almost stagnant market, participants in general do not seem worried, and believe the chance of liquidations is remote.
The US CLO market has been offering solutions to ease this build-up. A few CLO managers have opted to split warehouses to spread out underwater assets and to finish ramping up with discounted assets, creating “quasi print and sprints”, sources say.
“This is a win-win-win for manager, arranger and warehouse investor, as you get to mitigate risk as well as add AUM,” reasons a US CLO equity investor.
But Edwin Wilches, co-head of securitised products at PGIM believes this tactic could cause problems later. “Going forward, you’re going to have supply overhang from these split warehouses that will give the market some indigestion as it tries to process them.”
Despite the availability of cheap assets, CLO managers are not heavily ramping their warehouses. An arranging bank highlighted that the rate of ramp is being controlled and CLO managers are only ramping if they have an exit strategy with triple A CLO investors in place.
Print and sprint CLOs have played a major role in the continuation of the US primary market, but in Europe pricing these structures is more difficult. A lot of that boils down to the European loan market being much less liquid. “Print and sprints are more difficult in Europe because you cannot execute on the ‘sprint’ portion of the equation,” says III’s Pellegrino.
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Global credit funds & CLO's
July 2022 | Issue 247
Published in London & New York.
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