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July 2021 | Issue 236
Flat Rock completes hat-trick of CLO funds taking top spot
Hedge funds that invest in CLO tranches are the top performers in our database for a third month in a row.
Flat Rock Opportunity Fund gained 3.7% in May to follow April leader BK Opportunities Fund IV (managed by Crystal Funds) and CLO Alpha Compartment Taunus (CIS Asset Management), which topped the tables in March.
CLO funds occupy seven spots in our top 10 and the dominant run coincides with a period where debt spreads have slowly widened. The outlook for the market is bright with numerous investors picking new issue CLO equity tranches as their favourite trade.
CLO funds are up 8.45% this year, according to our database.
CLO investors don Euribor caps to hedge rising rates
Euribor-capped tranches have made a comeback in European CLOs, with AIG and PGIM understood to be behind them. Sources say PGIM has been investing in triple A-rated tranches, while AIG has taken on double-A rated tranches.
Investors who accept Euribor caps generally believe interest rates will not rise as much as the market is pricing in. As such, they accept the Euribor cap, which limits upside, in return for a higher spread.
Recent CLOs to feature such tranches include Palmer Square’s European CLO 2021-2 and CBAM’s Vendome Funding CLO 2020-1. Palmer Square’s regular triple As, for instance, pay 93 basis points, while a pari-passu triple A tranche pays 130bp but features a 2.1% cap.
Several deals earlier in the year featured Euribor caps on double As. KKR’s Avoca CLO XII, for example, which priced in March, featured a 3% Euribor cap on a double A-rated tranche, while Spire Partner’s Aurium CLO VIII featured a fixed-rate tranche that converted to a floating-rate after reinvestment with a 2.5% Euribor cap and zero floor.
One CLO manager tells Creditflux there is a balance with having the cap on the triple As because “sometimes it allows you not to have fixed rate on the double As, which comes with a wider coupon than the floater”.
Managers with large bond buckets may also choose to feature Euribor caps, according to one CLO syndicate head.
“If a deal with a large bond bucket wasn’t perfectly hedged, there could be a scenario where if rates have gone up dramatically, equity cash flow would be severely reduced as the outgoing liabilities have increased,” he says.
CLO arrangers roll out carpet for ESG CLO warehouses
US arranging banks are offering looser warehouse terms to CLO managers if they can confirm that the resulting CLO will be compliant with environmental, social and governance (ESG) criteria, sources have told Creditflux.
Bankers say their boards want to underwrite more ESG transactions, leading to the new warehouse offerings. And market participants, from corporates up to end investors, have made ESG a key policy objective, increasing its salience in the market this year.
ESG is just one aspect of how warehouse terms are loosening. The trend towards looser terms has historically coincided with positive market conditions, when banks are forced to entice potential clients with generous deal offerings in a bid to grow their market share.
The contrast is stark with 2020, when several warehouses triggered drawstops following the onset of the pandemic and were barred from trading.
Spooked by the loan market index falling into the 70s and the pace of downgrades, prospective CLO managers had to agree to onerous conditions, including allowing the underwriter to approve all purchased assets twice — between trading and settlement dates.
Later in the year, deal participants would split warehouses in two, combining the troubled asset pool with better-priced loans in order to empty warehouses that were under water.
With most analysts forecasting a record year for CLO issuance, banks are putting together more competitive offerings again. Reports emerged this month that large arranging banks were dropping their mark-to-market warehouse terms.
Quantitative credit growth could fill in ESG blanks
Quantitative credit strategies have the potential to “advance 20 years in the next two years,” according to officials at Man Numeric.
Few credit fund managers operate quantitative strategies, but there is a move towards data-orientated approaches. One use of these strategies could be to fuel growth in ESG, an area which is expanding at a rapid rate despite being stymied by a lack of data.
“We are excited about the prospects for ESG and climate research,” says Paul Kamenski, co-head of credit at Man Numeric, which is Man Group’s fundamental-driven systematic investment manager. “Credit is fragmented, but by using text sources, including a borrower’s historical data and news intelligence, we can gain an insight into a company’s ESG standing.”
Boston-based Kamenski says developments in quantitative credit are taking place rapidly. “The way we trade has changed, even from a year ago,” he says. “There has been a massive evolution on dealer desks with a pick-up in algorithmic trading, which means we can transact through electronic trading platforms and directly with traders.”
Numeric largely trades high yield and investment grade bonds because breadth of opportunity set is central to its approach.
Credit grind pushes back volatility bets
With recent weeks having all-but crushed volatility from the market, uncertainty about the timing of future risk triggers is leading credit options traders to spurn traditional horizons to focus on longer-dated expiries.
“We’ve seen sellers of volatility moving further along the calendar as there is definitely not much value left in the front months, with daily break-evens below 1 basis point in iTraxx Europe for instance,” says one credit options specialist at a bank in London.
Credit trading in June was characterised by a grind of indices to their tightest levels since the covid-19 pandemic hit last year, with the iTraxx Europe and CDX IG investment grade indices at 46.5bp and 47.75bp at time of press. Historically, sub-50bp levels have often been followed by 10bp or more of widening in the following three months, but few investors have been willing to sell volatility on this timeframe.
Even so, BNP Paribas has advocated the CDX IG September 55-70bp payer spread as a preferred hedge, noting this would allow investors to either unroll or unwind at “little loss of time value” if the July US Fed meeting proves uneventful.
“Out-of-the-money payers are extremely expensive in relative terms,” states a BNP Paribas research note. “For instance, the CDX IG three-month 80bp payer prices at the same implied volatility as when CDX IG was 30bp wider than today. Volatility should rise with wider spreads around the at-the-money, but past patterns suggest that for strikes above 70bp volatility should be little changed.”
Equity market volatility remains more elevated than credit. But even so, the CBOE Vix reached 15.5 in June, its lowest level since the covid-19 pandemic hit last year.
CLO demand drives loan outperformance versus bonds
Leveraged loans could be set for their strongest run of outperformance over high yield bonds since 2017, say investors and strategists — if the CLO engine and an influx of money to funds continues to drive flows.
Loans have lagged in the post-covid rally, particularly in Europe. But bond spread compression and the growing weight of demand for loans should shift this trend, say sources.
Loans “typically perform well mid-cycle when more carry for a bit less liquidity is often a trade-off that works”, wrote BNP Paribas’s credit strategy team in a June note. Fundamentals are improving and the ratings trend is positive, added the strategists, but the main driver is demand.
There have been more than $13 billion a month of new CLOs in the US this year and €2 billion in Europe, says BNP Paribas. The bank expects $130 billion in the US and €30 billion in Europe by year-end, up 40% on 2020.
CLO reinvestment capacity is another big driver, with 90% of deals ($600 billion in the US, €140 billion in Europe) needing to reinvest proceeds from loan repayments into new loans. This is a key source of demand that can offset a fall in new issues, says BNP Paribas.
CLO market explores move out of Cayman amid EU clampdown
CLO market participants are exploring moving their special purpose vehicles out of the Cayman Islands following amended European Union rules that could designate the territory as a blacklisted tax haven.
Article four of the EU Securitisation Regulation was amended on 9 April, and will likely block investors subject to the legislation from purchasing Cayman-issued securities.
Law firm Paul Hastings has recommended its clients domicile CLOs in the British Virgin Islands instead, due to an overlap in service providers between the two jurisdictions. Other options include Delaware and Bermuda.
Sources say that Cayman law firms Appleby, Maples and Walkers are coordinating a seamless switch from the Cayman Islands to the BVI.
CLOs that are not EU risk retention-compliant will not be impacted. Also, UK-based investors are regulated by the UK securitisation regulation framework and are thus not covered in its scope.
In an email to clients, Appleby lawyers explained to investors that while the Cayman islands was recently removed from the EU’s tax haven list, the amended regulations pose a risk for EU investors.
“There is a mechanism in the EU whereby any country on the Financial Action Task Force (FATF) blacklist or the FATF monitoring list will be added to the EU list [of high-risk countries] more or less automatically,” the letter reads.
“Cayman therefore expects to be placed on the EU list in due course, not because the EU has made any adverse assessment of the jurisdiction (quite the opposite), but merely as a result of being placed on the FATF monitoring list.”
UK government seeks views on securitisation regulation
The UK government has issued a ‘call for evidence’ for the securitisation regulation, the main law that regulates securitisation activities in the UK. Responses to this will inform the government’s review of the regulation, in a report that will be presented to parliament by 1 January.
The government says the aim of the review is to “bolster securitisation standards in the UK, in order to enhance investor protection and promote market transparency” and to “support and develop securitisation markets in the UK, including through increased issuance of STS (simple, transparent and standardised) securitisations, to ultimately increase their contribution to the real economy”.
The government seeks views on how the UK’s securitisation market is performing and how the regulation can be tailored to the UK. The consultation will end 2 September.
CLOs fall outside the scope of STS guidelines because they are managed products where the portfolio is turned over. Further, sterling-denominated CLOs have fallen out of favour in recent years.
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Global credit funds & CLO's
July 2021 | Issue 236
Published in London & New York.
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