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A number of CLO managers are shifting defaulted assets into sidecar vehicles before their transactions close — and sources say a growing number of debt investors are warming to the idea.

Known legally as ‘excluded obligations’, the assets can be excluded from the CLO collateral after closing, moving instead to a separate ‘excluded obligation collateral account’. From there, the manager can make investment decisions unrestricted by the CLO documentation.

The strategy has existed in refi and reset transactions for some time as managers looked to restructure seasoned portfolios with defaulted assets on the books. These sidecar arrangements have not historically featured in new issues, but became necessary for some CLOs that ramped into the coronavirus environment.

Nick Robinson, partner at law firm Allen & Overy, says that without these agreements, ineligible CLO warehouse assets would typically have to be sold, subject to warehouse terms. But there may be cases where it is beneficial for the manager and equity to hold onto the asset and try and work it out.

“It may not be beneficial to impose an obligation on the manager to sell a defaulted asset if it was believed to be a credit where some value could be gained in the course of a work out, as opposed to getting some haircut value at the time of sale,” says Robinson.

Without sidecars CLO managers would be disadvantaged compared to hedge funds and distressed debt investors in a loan restructuring. Not all senior debt investors are on board with sidecars, but some have been convinced by their high loan recovery rates.

A lack of demand for primary equity could lead to a drought of new CLO issuance in the second part of this year.

According to market sources, BlackRock was among the only firms to have bought majority equity CLO positions in May. In most other cases, CLO managers have only been able to print deals if they retain a majority of their equity, although there has been interest in minority positions. A spokesperson for BlackRock declined to comment.

CLO liabilities have lagged the leveraged loan market in the recovery. Triple A spreads are stuck in the 170s, and have slightly widened in secondary from the low to high 170-basis-point-range as Creditflux goes to press.

With the S&P/LSTA Leveraged Loan Index returning to the 90s last month, many equity investors say that the pressure on CLO arbitrage levels is mounting.

With uncertainty remaining around the nature of the recovery, many investors are modelling low teens or even single-digit returns on equity, and say that better value can be found in lower rated debt CLO tranches.

“Given where things are pricing, to make equity work you need to be extremely bullish and think there will be a V-shaped recovery,” says one CLO investor. “Given potential pitfalls such as warf-related trading restrictions and short reinvestment periods, it’s hard to see the upside.”

The first successful CLO equity b-wic following the pandemic sell-off took place last month, with several sources telling that insurance company Liberty Mutual was behind the auction.

Investors say they have found equity to be illiquid through the covid-19 crisis, with a scarcity of paper available on b-wics — although an increasing proportion of trades are taking place privately. Some say that off b-wic trades have grown to more than 50% of the market, in stark contrast to the oil and gas crisis of 2016, which saw a glut of b-wics.

Liberty Mutual announced it was building out its CLO investment capability in 2018, and the team is based in the insurer’s Boston headquarters. A spokesperson for the company declined to comment.

The b-wic featured many more recent CLOs, which were little impacted by downgrade action as a result of the crisis and less likely to be in breach of their over-collateralisation tests.

Cedar Funding X and Palmer Square Loan Funding 2019-2 traded in 2019 at covers of 65.15 and 53.31 cents, respectively.

California Public Employees’ Retirement System has outlined plans to boost returns for its nearly $400 billion portfolio in the long term. But the proposal, dubbed ‘towards a 7% solution’, has come under criticism after chief investment officer Ben Meng admitted that the chances of hitting the 7% target were less than 50-50.

The strategy has two components: “better assets” and “more assets”, Meng said on the 15 June board meeting call. The better assets strategy uses private assets that have potential for higher returns and lower volatility compared to publicly traded assets, he said. “More assets” refers to using leverage.

“The use of a moderate level of leverage allows Calpers to take advantage of low borrowing costs to acquire assets which potentially have higher returns,” Meng said.

He acknowledged that the approach carries risk because leverage can exacerbate volatility. But it can also reduce risk over time, said Meng, “allowing us to keep more exposure in diversifying assets, such as US treasury bonds, while pursuing higher returns in other parts of the portfolio”.

The strategy has drawn criticism. During public comment, retired California prosecutor David Soares expressed his concern. He said the leverage plan was speculative and an “inappropriate strategy for a fiduciary charged with protecting public trust assets”. It adds risk of “losing trust assets to credit failure and bankruptcy during the coming global pandemic downturn”, he added.

Calpers also approved the increase of opportunistic allocation from 3 to 5%, allocating $1 billion apiece to Oaktree Capital Management and Oak Hill Advisors.

A new version of the iTraxx Europe index screened for environmental, social and governance standards began trading three months after its intended roll-out was delayed by coronavirus volatility.

In its first day, on Monday, 22 June, the iTraxx MSCI ESG Screened Europe index held firm against a 1.75bp widening in the Europe main index.

“Multiple dealers started quoting the new iTraxx MSCI ESG Screened Europe index today,” says Srichandra Masabathula, a senior specialist in indices at IHS Markit. “The index’s composite price spread stands at 57 basis points — compared to 67 basis points for the overall iTraxx Europe index.”

Trading flows for a new index are typically slow in their first sessions, while market participants test the water. But IHS Markit is encouraged by the ESG index’s start.

“For IHS Markit to establish a composite price spread, we require price contributions from at least three market participants, so it’s exciting that we met this benchmark on the first day of trading,” says Masabathula.

Frank Soussan, global head of LCH’s CDSClear platform, hopes soon to be able to clear the iTraxx ESG index. “We are looking to launch clearing early August, pending regulatory approval,” he says.

The ESG index has 81 constituents at launch, 24 fewer than iTraxx Europe.

Governance has more impact than environmental and social factors on company financial fundamentals and stock price in the short term, but ‘E’ and ‘S’ play their part over the long term, according to analysis from MSCI.

Results from the paper “Deconstructing ESG Ratings Performance”, which looked at the period between December 2006 and December 2019, found that, based on the MSCI ESG score, governance was most significant over a one-year horizon.

Financial markets largely focus on events that can immediately affect company valuations, which tend to be associated with governance factors, including fraud or ethics breaches, MSCI says.

Environmental and social scores represent underlying industry-specific issues, only some of which trigger tangible, event-driven risks such as accidents, strikes or oil spills. MSCI added that environmental and social factors, including managing human capital, can lead to a “risk of erosion” to competitiveness and degraded financial performance over a long time period.

In the analysis, the highest scoring companies outperformed the lowest by between 7% (for S scores) and 31% (for aggregate ESG scores) on a cumulative basis.

CDS index tranche trading has gathered pace during the coronavirus pandemic, putting the asset class on course for a post-2008 crisis record. This comes at the same time as an evaporation of new business in the synthetic bespoke tranche market, which has lain all but dormant in recent months.

It had been hoped the primary pipeline for CSOs would begin to grind back into gear by the end of June, as old CDS contracts backing existing products matured. But a senior structured credit official at a bank in New York told Creditflux ahead of press that new CSO business remains quiet.

Not so the index tranche market, the same official said, adding that trading volumes so far this year could be in the region of $175 billion notional. The full-year total for 2019 was $250 billion, which in itself was a lot more than previous years and underscores growing appetite for a commoditised form of structured synthetic risk.

CDS index administrator IHS Markit does not have precise figures on traded tranche notional, given the recent extreme movement of markets. But a spokesperson said the firm is seeing “an observable trend of 2020 outpacing 2019”.

One aspect of index tranches that has given them an advantage over CSOs is their standardised format and underlying portfolio. This makes them easier to enter and exit quickly, but also means participants can delta-hedge tranche holdings against outright directional market movement via an offsetting index position, leaving a pure view on correlation.

Index tranche investors have found lucrative opportunities to trade in and out of delta-hedged equity and junior mezz during the pandemic.