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January 2022 | Issue 241
CLO funds shine amid the gloom with unmatched returns
Credit funds stumbled in October, with European high yield, emerging markets and long-short strategies the weakest performers, according to Creditflux data, as several funds in these categories suffered losses. Amid the malaise, CLO funds outperformed (again). Our index for CLO funds gained 1.06%, underlining the ability of CLOs to produce returns uncorrelated to other credit strategies.
Fair Oaks and Oxford Funds — two of the biggest CLO equity buyers in the business — each had two entries in our list of top 10 funds for October.
Brace yourself for tiers, tightening and titanic CLO issuance
The European CLO market has shattered post-global financial crisis new issuance records in 2021 with €38.4 billion pricing, as Creditflux goes to press. But 2022 could prove even more abundant. Amid a positive loan outlook, arranging banks are predicting €35-40 billion of CLO issuance driven by tighter triple A pricing.
A European CLO manager says issuance will stay high, with triple A spreads anticipated to tighten in Q1 and Q2. “We’re bullish on triple A tightening and it’s partially driven by the fact that there will be less reset and refi activity because all the low hanging fruit — CLOs issued in 2020 with high cost of debt — has been reworked during 2021.”
The manager thinks more depth in the investor base will result in greater tiering.
Muzinich’s global head of CLOs, Brian Yorke, says he is bullish on the leveraged loan market and expects the same level of resilience in 2022 as in the past two years.
“It’s likely we’ll see more [covid] variants and degrees of severity throughout the year, but at the same time we have a plan on how to go about dealing with it without locking down large areas of the economy,” he says.
On top of that, Yorke says there has been deep support from the private equity world with unprecedented amounts of dry powder.
“It also mirrors well for loans and CLO debt that you have a rising rate environment amid inflation fears and migration to floating rate paper,” he says. “It’s a constructive environment going into 2022 with low defaults, low triple Cs, very few names trading below 90, plus the roadmap on how to deal with the healthcare scares.”
Infra CLO becomes first to opt for solely Sofr benchmark
The first CLO to dine completely on Sofr tranches wasn’t a run-of-the-mill deal. Instead it was an infrastructure-loan securitisation issued by Starwood Capital at $500 million, named STWD 2021-SIF2, according to market sources.
Deutsche Bank priced the CLO on 29 November. It features a 1.5-year non-call period and three-year reinvestment. The CLO’s floating rate triple As priced at Sofr plus 155 basis points and sources say 13 investors invested in the deal’s debt tranches, eight of them in the triple As. Unusually, the CLO does not feature a credit spread adjustment.
Hsiang Lim, the bank’s global head of CLO new issue, says there was robust demand from investors. “The CLO is uniquely positioned through direct origination of the collateral and retention of CLO equity to be able to consider term Sofr CLO debt issuance,” he says.
The underlying assets consist of first-lien senior project finance and corporate infrastructure loans. The deal marks Deutsche Bank’s first credit for an infrastructure CLO and Starwood’s second CLO after a deal it priced on 23 February. That deal priced triple A notes at 150bp over Libor.
Deutsche Bank research analysts wrote last week they anticipate CLO quotation convention to eliminate the reference to credit spread adjustment. Instead they expect Sofr plus credit spread to be the common way to compare bonds.
First Euro CRE CLO points to likely growth market
CRE CLOs have been identified as a likely growth market in Europe following the successful pricing of the first transaction on the continent, according to sources.
The CLO, named Starz Mortgage Securities 2021-1, was arranged by Credit Suisse and is backed by commercial real estate loans originated by Starz Mortgage Capital. The loans backing the CLO are secured by real estate in Ireland, the Netherlands, Spain and the UK, while both the assets and liabilities are denominated in a mix of sterling and euros.
Nick Shiren, partner at Cadwalader Wickersham & Taft in London, says the market is set to expand in 2022. “There has been a huge amount of interest from both the sponsor and the bank side,” Shiren says. “There is talk of another two deals floating about now, and I’d expect to see a handful done in 2022.”
Arrangers are hoping the European CRE CLO market will mirror that in the US, where issuance has boomed in 2021 to over $30 billion.
Starz Mortgage Securities 2021-1 has around €260 million in assets. Shiren says its simple structure, small size and static collateral pool were deliberate choices for a first-of-its-kind deal. He hopes the market will follow the US in allowing reinvestment.
Market ponders Sofr spread adjustment amid investor lag
The CLO market is waving goodbye to Libor as a benchmark rate and transitioning to alternatives for the first time in the history of the asset class. But there is no consensus as to what the Sofr spread adjustment should be, and some of the largest buyers are said to be slow to consider the impact of a benchmark transition.
CLOs referencing Sofr have slowly begun to trickle in, with Onex Credit Partners’ OCP 2015-10 the first to link to Sofr when it reset via Nomura. While no regular CLOs have priced a full Sofr-linked stack as Creditflux goes to press, alternatives such as infrastructure and commercial real estate CLOs have priced a complete set of Sofr-linked notes.
With limited CLO issuance linked to Sofr, market participants are yet to finalise pricing for deals referencing the new benchmark rate, but they agree that the Alternative Reference Rates Committee’s recommended 26 basis points is too wide. Onex’s deal and Marathon 2021-17, which priced in November, paid wide of their equivalent Libor-based tranches by 15bp and 20bp, respectively. The Onex CLO has a three-year reinvestment, while Marathon has five years.
“Things are going to slow down as the market finds a level to price going forward,” says Michael Herzig, head of First Eagle Investment Management’s alternative credit business. “The market is still not in agreement as to what that level should be and needs a meeting of minds between the big CLO issuers and the big buyers.”
Most CLO market players say their firms are prepared to make the switch, but concerns have been expressed about the readiness of some Japanese banks to make the transition.
Record US CLO volumes predicted as warehouses boom
CLO market forecasts for 2022 suggest another strong year for US primary market volumes. The factors that led to record volumes in 2021 — high savings rates leading to a strong bank bid for the triple A tranche, a deep pipeline for leveraged loan issuance, a low default rate and an attractive equity arbitrage — are predicted to buoy CLO issuance again into the new year.
Bank of America’s US CLO research team is projecting $155 billion of new issues and $120 billion of refis and resets, noting that the number of warehouses open is double the figure at year-end 2020.
“The number of warehouses has almost doubled, which should result in elevated issuance volumes,” wrote strategists Pratik Gupta, Chris Flanagan and Siddhant Mohanty. “At current debt/spread levels, equity arbitrage remains healthy and loan fundamentals should result in continued issuance in the near to medium term.”
CLO activity is also predicted to remain heightened in Europe, where a busy M&A pipeline means loan spreads should remain wide, while rate rises should mean high demand for liabilities keeps spreads tight and the arbitrage appealing.
TwentyFour Asset Management partner and portfolio manager Aza Teeuwen wrote in December that European CLOs were one of his firm’s top picks for 2022. “For the whole of 2022 we expect increased volatility, so timing and trading will be crucial, but in general we see slightly tighter spreads by the end of 2022 across the capital structure and some solid coupon clipping.”
Relative value traders seize on fleeting mismatches
The volatility that hit credit markets from mid-November has produced rare opportunities for relative value traders after a dearth for 12 months. But sources say subdued liquidity and narrow windows may limit the scope to profit.
The discovery of the omicron covid-19 variant blew out credit spreads in late November, with big moves wider across all CDX and iTraxx indices. But within portfolios there was an increase of idiosyncratic movement, which has changed the picture for index tranche traders.
“Investment grade indices have underperformed versus high yield,” says one New York based investor. “But correlation has gone down, leading to a greater preference among investors to short CDX HY equity tranches — although long beta players have also come in to buy the dip.”
According to a European portfolio manager, single names drove most of the relative value movement between high yield and investment grade, or US and European indices during recent turmoil. Big movers in CDX HY included Talen Energy, which gained nine points in up-front CDS trading to 56.5 PUF. In European high yield the headlines were dominated for a while by Adler Real Estate, whose five-year CDS has oscillated across a wide range.
But the European PM stresses any trading on falling correlation versus rising idiosyncratic risk will be short-lived.
“Federal Reserve tapering in the US will trigger a general move in spreads and hence argues for rising correlation,” he says. “The moves we’ve seen lately have not been a general trend in markets. That definitely might change sooner rather than later when the Fed intensifies its activity.”
Brace yourselves for increasing ESG basis in credit
One of the safest bets in credit for 2022 is that ESG focus will intensify, with market participants anticipating a surge of green bond issuance as well as widening spread dispersion between climate leaders and underperformers.
In BNP Paribas’ 2022 outlook, strategists predict a 60% rise in green bond issuance, with pledges outlined at the COP26 summit helping to shape sustainable financial markets.
Investments in renewable energy, electric vehicles and industry transitioning will mean more green bond issuance from NextGenerationEU, corporate borrowers and emerging markets, they add.
CLOs with ESG criteria have so far been limited and liability pricing barely differentiated, note JP Morgan strategists. But issuance is picking up and CLO resets have also started incorporating ESG language.
Indicative analysis so far suggests a lower equity return for the ‘cleanest’ hypothetical CLOs, but the bank concedes it is ‘early days’, and that investors may increasingly allocate capital to CLOs contributing to sustainable financing.
Bank of America strategists believe S&P’s surprise downgrade of the global oil and gas sector in 2021 due to ESG factors was the first of its kind. They add that eligibility for purchases will become a function of disclosure on emissions.
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Global credit funds & CLO's
January 2022 | Issue 241
Published in London & New York.
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