May 2021 | Issue 234
Analysis Credit
CLOs come up smelling of roses
Sayed Kadiri
Editor
Michelle D’souza
Reporter
The coronavirus crisis could have cut back 10 years of CLO market progress, but investors’ foresight, trading chops and flexibility meant many saw their strategies blossom during 2020
The decade of prosperity for CLO investors — which began in March 2010 with the pricing of the first CLO 2.0 (Fraser Sullivan Investment Management’s COA Tempus) — seemed about to come to an abrupt halt in March 2020. But although the sell-off triggered by the coronavirus pandemic brought a reminder that CLO test failures and downgrades can happen, some of the biggest CLO investors tell Creditflux that, unlike 2008, when CLOs were castigated, this time around they earned respect for their ability to weather a storm.
De-risking began in 2019
Miguel Ramos Fuentenebro, co-founder of Fair Oaks Capital, says his firm had concerns about valuations two years ago and started de-risking portfolios across strategies in 2019. Fair Oaks stepped away from primary US CLO equity from 2018 and sold part of its CLO equity portfolio in late 2019. “Most of our vehicles faced the March sell-off with their most conservative historical asset mix since their respective launches,” he says.
Other investors began preparing early in 2020. Ares Management’s Ian Smith, for example, says he began wearing face masks on flights in January. The firm’s co-head of alternative credit, Joel Holsinger, warned colleagues that a worldwide health risk was on the horizon after he heard about covid-19 through his Asia-centred charity work.
And Pearl Diver Capital acted on warning signals by starting a work-from-home programme in London in late February.
“We started kitting people out with dual screens and laptops at this point, and by the start of March we were pretty much all working remotely,” says Pearl Diver chief executive officer Neil Basu.
What goes down, must come up
Sources: S&P/LSTA ; CLO-i
The clearest indications that problems were afoot came, ironically, as the CLO market took part in a mass gathering at the annual Las Vegas ABS conference (23-26 February 2020), which is hosted by the Structured Finance Association.
“It probably shouldn’t have gone ahead,” says Amir Vardi, head of structured credit in the credit investments group at Credit Suisse Asset Management. “I don’t remember a lot of elbow bumps but the impact of the coronavirus was a question that came up in every meeting.”
Shortly after the Vegas event, stock markets crashed and US CLO spreads began to slip wider, with the last primary market deal — Trinitas CLO XII — pricing on 13 March. The five-year reinvestment CLO issued senior notes at 133bp.
“Our trade volume was larger than 2016, 2017, 2018 and 2019 combined”
Neil Basu, Chief executive officer | Pearl Diver
From that point onwards there was uncertainty in credit as lockdowns ensued globally. Several CLO investors say they knew the sell-off was different to any previous crisis when a b-wic was scheduled on Sunday 22 March.
“This was a $200 million b-wic on a weekend and we knew then, when you could not get investment grade corporate bonds cleared,” says Los Angeles-based portfolio manager Smith.
On Monday 23 March, credit reached its lowest point since July 2009 as the S&P/LSTA US Leveraged Loan Index dipped to 76.23. CLO valuations plummeted. Triple A-rated US CLOs were trading in the high 80s (400-plus basis points in discount margin terms). In fact, investors started talking about CLO valuations in terms of dollar price rather than DMs — a sure sign that these were now stressed assets.
“Up to the Friday before [20 March] we raised liquidity in our CLO debt portfolios,” says Ramos Fuentenebro. “We were able to sell assets close to par in early March and in the 90s until 18 March.”
Liquidity creates opportunities
Dan Wohlberg, director at Eagle Point Credit Management, says his team had conversations with warehouse lenders early in the crisis. “We wanted to ensure we could continue to provide capital so that managers who were ramping CLO portfolios were able to keep buying loans,” he says.
Other opportunities were generated by CLO holders selling out of investment grade or lower rated CLO tranches in order to generate liquidity in fund structures that promised liquidity to investors (the fact the sell-off happened at the end of a quarter exacerbated this dynamic). Funds that had capacity to buy and had conviction in their strategies were the winners at this time.
“This was a $200 million b-wic on a weekend”
Ian Smith, Portfolio manager | Ares Management
In fact, Napier Park Global Capital had a strategy waiting in the wings for exactly this sort of market crash, having established an ‘accordion’ strategy years earlier. This type of fund lies dormant until a specific trigger is hit. In Napier Park’s case, high yield spreads and CLO double Bs had to hit extremes before it could call on investor commitments.
Such opportunities do not come by frequently, says Napier Park’s head of structured credit Serhan Secmen. “The strategy would also have triggered in 2016 following the oil and gas sell-off and for a brief period in late 2018,” he says.
Fair Oaks had its own dislocation strategy in the form of Fair Oaks Credit Opportunities 2018-1, which was undrawn until March 2020. “We started deploying our credit opportunities fund on 20 March, conservatively buying single A-rated European notes in the 60s and 70s,” says Ramos Fuentenebro in London. “We dedicated Monday [23 March] to internal strategy and planning discussions on how best to navigate the challenges ahead and our trading resumed two days later.”
“We started deploying our credit opportunities fund on 20 March”
Miguel Ramos Fuentenebro, Co-founder | Fair Oaks Capital
The timing also worked well for Credit Suisse Asset Management, which raised a CLO equity fund that held a final close in October, and for Pearl Diver, which ramped up Pearl Diver Capital 8 in March. “We use an automated investment engine and on a typical day you could hit 200 emails, but it exploded in March with the sheer number of CLO opportunities in the market,” says Basu.
But fund managers did not buy and wait for their CLO investments to appreciate — 2020 was about capturing relative value by shifting between tranches, crystallising gains, redeploying capital and, at times, hedging risk. This meant CLO investors had their busiest year on record.
Fair Oaks, which had $1.2 billion in equity, mezzanine and tactical funds in March 2020, traded over $450 million in the second quarter. And Pearl Diver’s Basu says: “Our trade volume was larger than 2016, 2017, 2018 and 2019 added together.”
Napier Park’s Secmen was busy through to the end of the year. In the early part of 2020, his firm was a big buyer, then it moved to rotate its portfolio more equally with buys and sells, before harvesting gains.
“We were selling via b-wics almost every day from 18 November until the markets closed at the end of the year,” he says. “Through our deep value strategy we bought $3.9 billion of assets globally and sold $1.8 billion in notional in 2020, and we were consistently told by CLO traders that Napier Park was their number one counterparty.”
“We invested almost entirely in the secondary market in Q2”
Amir Vardi, Head of structured credit (credit investments) | Credit Suisse Asset Management
Relative value shifts from junior debt
To make the most of their opportunities, investors had to be nimble. For example, Ares pursued double B-rated CLO tranches in the early stages of the crisis.
“The market was so focused on market value OCs,” says Smith. “We looked at underlying credits and saw there was value in double B tranches trading in the 70s.”
The attention on overcollateralisation ratios came as CLO triple C buckets filled up and triggered OC test breaches. Michelle Manuel, portfolio manager at Investec, invests in middle market CLOs and says upper mezz looked secure.
“We ran stress tests to confirm the robustness of double-A and single-A rated tranches based on what we had seen during the global financial crisis, but with harsher recoveries,” she says. “Under these extreme stresses some of our single As looked slightly concerning, but did not lead us to believe they would be sufficiently stretched to warrant downgrades.”
“We did not believe single As would be so stretched as to warrant downgrades”
Michelle Manuel, Portfolio manager | Investec
In Q2, the primary US CLO market opened with a trickle in April and then with $5.6 billion of issuance in May and $6.9 billion in June. These CLOs were more or less pristine, with managers having shed any covid-affected loans prior to issuance. They were also short-dated, with a range of one, two and three-year reinvestment periods.
Generally, warehouses were not needed to get CLOs launched last year, says Vardi, as CLOs were ramped using secondary loans purchased in block trades.
Some believe the secondary CLO market offered more value than new issues. “The convexity was better in the secondary market,” says Smith. “You could buy a new issue triple B at par paying 500bp, or alternatively a secondary triple B at 75-80 cents. I’d rather take the 20% return than 5%.”
CSAM’s Vardi concurs: “We invested almost entirely in the secondary market in Q2. By May, the CLO equity freeze had thawed out and through to the end of July we were able to source a decent amount of equity issued by top-tier managers.”
“We now see greater numbers of investors who view CLOs as attractive”
Dan Wohlberg, Director | Eagle Point Credit Management
CLO equity came into focus as the corporate credit outlook improved and credit rallied in late April. CLO debt would eventually rally back towards par, but holding paper until the recovery was complete would have come at a cost.
“By the end of the second quarter we sold double Bs in the 90s having bought them in the 50s and reallocated to equity,” says Ares portfolio manager Charles Arduini. “We did not wait for every last dollar before acting decisively.”
However, Pearl Diver, which is one of the prominent investors in anchor CLO equity, did not dabble in this part of the market until the end of 2020. Basu says the firm had changed its fund architecture over the past few years so it could buy mezzanine tranches and it capitalised by investing in triple Bs and double Bs for much of the year. “We did not touch equity until December because we got enough return in mezz.”
Talking about dislocation
Throughout this time fund managers had detailed conversations with investors but — in a clear indication of how far the CLO market has developed — these conversations were on how to capitalise on dislocations, rather than on liquidation.
Ramos Fuentenebro says the focus was on detailed analysis of potential investments, due diligence and risk management and controls and “definitely not a time for glossy pitchbooks”.
By September, First Eagle’s Wind River 2020-1 became the first five-year reinvestment CLO priced following the covid sell-off. But already investors were considering the risk of a second wave of the virus as economies began to open up.
Secmen says that Napier Park’s deep value strategies reduced exposure to CLOs gradually over the course of 2020. The firm rotated into high yield tranches, credit derivatives and ABS as the CLO rally appeared to peter out and other forms of structured credit appreciated. The ploy worked, with Napier Park generating a 72% IRR through the strategy.
Pearl Diver went a step further and looked to outright hedge against rising credit risk. “We put on some shorts in the credit options market,” says London-based Basu. “Buying put options was relatively cheap and could pay off 15-times the outlay.” He says the hedges expired without being triggered.
In 2021 the CLO market rallied sharply before giving back some of those gains by the end of the first quarter. However, this was due more to an abundance of CLO supply — $167 billion as Creditflux goes to press — which caused spreads to soften, than any weakness in fundamentals.
“We were selling via b-wics almost every day from 18 November”
Serhan Secmen, Head of structured credit | Napier Park
Progress and vindication for CLOs
Overall, the CLO market has seen many positive developments in the past year, and that has brought in new investors. “If you look at how quickly triple As tightened at the beginning of the year, that was from some differentiated bidders too,” Eagle Point’s Wohlberg says. “More and more we see greater numbers of investors who view CLOs as attractive versus other asset classes — perhaps some of these recent buyers were more encouraged by the lack of CLO triple A downgrades or impairments in bouts of volatility such as covid.”
Basu says 2020 was a year of vindication for CLOs: “My faith in the CLO asset was reinforced. People always say that CLOs have embedded self-correcting mechanisms — and that belief was proved absolutely correct.”
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Global credit funds & CLO's
May 2021 | Issue 234
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