Credit investors eye synthetic tranches as dispersion rises

Dan Alderson

Deputy editor

Dispersion is increasingly important to the credit market — and it is incentivising some CLO investors to add synthetic products to their toolkits.

So far this year, CLO equity and 0-15% CDX HY first-loss tranches have generally outperformed the rest of their respective capital stacks as spreads have widened, while triple-A CLO paper and 35-100% tranches have underperformed.

But that dynamic is under scrutiny as market participants cast their minds back to 2019 when dispersion increased at the wide end of CLO, bespoke and index portfolios. This, in tandem with the steepness of CDS curves relative to cash credit, is encouraging CLO investors to broaden their repertoire.

“As we think about first loss pieces, in bespokes you are really making a choice around dispersion,” said Greg Borenstein, head of corporate structured credit trading at Ellington Management Group, on a panel at Creditflux’s Credit Dimensions event in New York on 31 March.

“We’re a little worried about idiosyncratic risk”

John Burkert, Head of direct credit | Duke University Management Company

“On the mezz side, it becomes more around roll down in curves,” he added. “We might look for something where the carry roll is attractive, whether it’s in a 15-25% index tranche, a second loss bespoke piece or CLO mezz. A lot of these things became more attractive in the spread widening shock, where it was felt that with some subordination and steepening that could really benefit.”

But given curves are flatter than in 2019, there is more appetite to put on trades of shorter duration than the five-year that was then customary.

CSO primary is making a decent comeback this year, with around $10 billion of business year-to-date, said BNP Paribas’s head of structured credit trading and financing Guillaume Mear on the same panel.

Bespoke equity remains an attractive prospect for those who specialise in that part of the capital stack. But both investors on the Creditflux panel expressed reservations about its suitability for them.

“We’re less interested in taking on bespoke equity risk, given defaults have been so low,” said John Burkert, head of direct credit, Duke University Management Company.

“Most people think they’re going to continue to be low, but we are in the later stages of the cycle and a little worried about idiosyncratic risk. We’re more interested in bespoke mezz or senior as a way to generate carry and then to use that to buy index protection or puts on HYG or other first loss hedges.”

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Global credit funds & CLO's

April 2022 | Issue 244

Published in London & New York.