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March 2022 | Issue 243
Hedge funds

HY fund is exception to rule of CLOs

Michelle D'Souza headshot
Michelle D’Souza
Robin Armitage
CLO funds have had back-to-back years of outperformance versus credit, proving the asset class is a great place to invest, rain or shine. But a Wasserstein HY fund was the star performer in 2021
CLO funds dominated Creditflux’s 2021 credit hedge fund rankings, but US high yield fund Wasserstein Debt Opportunities beat the competition to clinch first spot. It returned 52.95%, outperforming the Creditflux US HY index (which was up 7.63%).
Rajay Bagaria, president and chief investment officer at the firm, says the high yield strategy avoided beta and pursued less-followed segments, which had greater potential for price inefficiency and idiosyncratic event catalysts. High yield spreads at around 390bp heading into 2021 suggested a low margin for error.
Lupus Alpha secured second spot with its European CLO mezz and equity fund, Lupus Alpha CLO Opportunity Notes II. It was one of four managers (including CIS, Flat Rock and Wasserstein) to achieve back-to-back top 10 spots. Alcentra’s corporate distressed debt fund, Alcentra Global Special Situations Fund, rounded off the top three with 29.18%, beating the Creditflux index’s 16.74%.
CLO index vs credit hedge funds highest and lowest returns 2019-21
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Source: Creditflux Hedge Fund Database
CLOs outperform in ups and downs
Six CLO funds made our top 10, as the Creditflux CLO index returned 14.92% in 2021 (up from 2.99% in 2020).
Managers tell Creditflux that resets of 2020 deals largely attributed to stellar performances in 2021, with the lower cost of funding and extended cash-flows giving funds a bump in terms of valuation. Resets of 2020 European CLOs cut cost of debt by an average 44.5bp, while US CLOs cut 47.5bp, according to Creditflux data.
Inés Bartsch, chief executive officer at CIS Asset Management, says: “As we invested in CLOs throughout covid, several of those deals that reset/refinanced were beneficial for equity, especially as they ramped up around Q2 2020. For example, reset par flushes contributed to our 6.86% return in September 2021.”
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Michael Hombach, portfolio manager at Lupus Alpha, agrees that resets helped. “We positioned ourselves well while investing in short deals that had no added premium being paid. All these deals extended their reinvestment period and weighted average life, and increased in price. At the same time, they paid out in terms of valuation price. We had an annualised January payment in 2021 of 14% (notional).”
Fair Oaks Capital has been a long-time advocate of the control CLO equity strategy. Miguel Ramos Fuentenebro, partner at the firm, says the benefits shone through in 2021. “Investing in control equity means you can have a dialogue with the manager to decide key parameters while ensuring the portfolio and structure reflects your view as equity holders,” he says. “We have done deals with short non-call periods in 2020 for example, to maximise optionality.”
“Reset par flushes helped returns”
Inés Bartsch, Chief executive officer | CIS Asset Management
Fuentenebro believes the Wollemi Investments fund highlights the ability to make good returns with a conservative portfolio.
“The CLOs in the fund tend to have a lower spread than the market and more conservative portfolios. Applying appropriate assumptions to these portfolios supports attractive returns while facilitating future optimisation via, for example, resets,” he says. “It’s not all about aggressively high portfolio spread and a couple of high distributions, followed by potential pain.”
Olivier Gozlan, portfolio manager at Crystal Funds, says he attributes his CLO fund’s success last year to three factors. “2021 was a stronger year, supported by price and new entrants in CLOs (both on the sell side and buy side), which provided some liquidity. We also had intensive trading activity.” Gozlan adds that Crystal sacrificed some liquidity and looked for yield if the team were comfortable with fundamentals and credit analysis.
Reorg equity in CLOs was also a theme in 2021. US CLOs could hold non-loan assets following the Volcker rule amendments in October 2020. Debdeep Maji, senior managing director at Oxford Funds, says his firm targeted CLOs that used this flexibility.
“Increasing spreads will have an impact”
Stamatia Hagenstein, Portfolio manager | Lupus Alpha
“Through 2020, certain CLO managers held loans through bankruptcies or restructurings and took their recoveries in the form of reorganised equity in those companies,” says Maji. “In the secondary market, we targeted deals that held reorg equity as these profiles were often overlooked and not properly valued by the market.”
Serone, meanwhile, was one of two distressed managers in the top 10. Ralph Herrgott, head of special situations, attributes performance to an ‘event-rich’ year, with event-driven or hedged trades contributing to 69% of returns. Synergies with the firm’s CLO strategies and trading within the fund’s portfolio (turnover and volume of 128% and 257%, respectively) also helped, he says.
Managers prepare for volatility
Volatility will be a key theme in 2022 with credit managers needing to navigate geopolitical risks stemming from Russia’s aggression in Ukraine, Fed rate hikes and inflation.
Stamatia Hagenstein, portfolio manager at Lupus Alpha, says the CLO arbitrage could benefit deals with locked liabilities that are still in their reinvestment period and are able to invest into wider asset spreads. “We saw this in our CLO fund after the financial crisis, where the spread of the underlying assets jumped from 250bp to 450bp,” she says. “We don’t expect this to happen now, but if you are able to increase asset spreads from 10-25bp, it will have a beneficial impact on equity prices and cash outs.”
Maji expects to see opportunities in the CLO secondary market in 2022. “It’s been an interesting year so far in our market because until recently, loan prices were relatively strong despite the overall backdrop of the high yield and the equity markets,” he says. “Because of that dynamic, we’ve seen certain CLO equity profiles trading in the secondary market well below their liquidation NAVs, and we’ve managed to source a few interesting control blocks.”
Monthly returns 2021: CLOs (%)
Corporate distressed
Credit multi-strategy
Corporate long-short
US high yield
*Market average figures are taken from all other funds in the database.
Source: Creditflux Hedge Fund Database
For high yield, Bagaria argues that rate hikes will drive capital outflows, creating a technical price dislocation divorced from fundamentals and leading to substantial opportunities. “Unlike equities, where you can debate sales multiples and the proper long-term discount rate, high yield valuation is grounded in free cash-flow and a contracted maturity,” he says. “For managers in a position of strength, the inflationary backdrop creates opportunities to produce greater than 20% net returns in 2022.”
Herrgott agrees. “The monetary policy stance and rising input cost environment will likely lead to dispersion in the Euro HY market,” he says. He expects to see mis-pricings and a “balanced event set between re-financings, M&A and restructuring”.
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Global credit funds & CLO's
March 2022 | Issue 243
Published in London & New York.
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