Global credit funds & CLO's
May 2020 | Issue 223
Published in London & New York.
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May 2020 | Issue 223
CSO are hurting but will emerge stronger, say sources
Deputy editor
Dan Alderson
It is unsurprising that bespoke synthetic tranches have suffered during the covid-19 crisis, as they are backed largely by real money investors that have gone outright long credit risk. But more noteworthy and reassuring, say sources, is that most have held firm in their positions and look set to stick with the asset class — in contrast to the 2008 global financial crisis exodus.
CSO pain stacked up from the end of February. Lockdowns pushed up near-term default risk for numerous popular CDS names, a bigger headache for two and three-year bespokes than the five-year maturities that characterise index tranche investments. Credit events are so far limited to a few US companies rarely featured in portfolios, but mark-to-market and margin calls have taken their toll on buyers who used leverage.

“Bespoke CSOs generally underperformed index tranches in the sell-off, mainly due to flatter CDS curves and the general cheapness of CDS versus indices,” says Guillaume Mear, head of structured credit trading at BNP Paribas in New York.
But while equity and mezzanine tranche investors in particular were hit hard, there have been few signs of fire sales, liquidations or investors being closed out of positions. On the contrary, new money is entering at wider spreads, taking the view that most idiosyncratic risk is priced in and volatility looks to be abating.

“A few accounts reduced their allocation, but others seized the opportunity to deploy fresh capital into the asset class,” says Mear. “While new deal activity paused over the past month, secondary flows picked up.”

Portfolios are geographically diversified and tended to avoid the riskiest names, making them closer to investment grade than high yield indices in correlation terms. Ironically, this would have caused CSO equity to underperform the rest of the stack if investors had delta hedged. Anecdotally some investors were caught out by matching longer tenor index hedges against CSO holdings, but sources say this is unusual. Specific single name hedges were more the norm, rendering bespokes a CDS rather than correlation story.

Shorter duration has helped keep mark-to-market down, says a senior official at another firm, adding that the ability to hedge gave CSOs an advantage over some securitised products.

“Overall, this has been a robust test for the product,” says Mear. “Investors did not enter the March sell-off over-levered and found more liquidity than anticipated, while dealers’ trading books didn’t come under stress.”

The next key test for longevity will be whether new bespoke deals start to emerge, particularly as old deals mature.
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“New deal activity paused, but secondary flows picked up”
Guillaume Mear, Head of Structured Credit Trading | BNP Paribas