Global credit funds & CLO's
June 2020 | Issue 224
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News in brief
June 2020 | Issue 224
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Index equity tranches show resilience in face of default spike
Lower credit index volatility in May refocused investor minds on idiosyncratic risk, with some give-up by previously outperforming equity tranches.
Credit index spreads traversed narrower ranges in May and April than March. But lack of relative value movement between equity and mezzanine tranches, as well high base correlation, suggest investors are unconvinced that the broader impact of coronavirus is abating.
“In our view, this is not only a spike but a systemic problem with lasting effect,” says Jochen Felsenheimer, managing director at Xaia in Munich.
As yet no defaults have hit iTraxx Crossover, although several names are moving towards triggering. At time of press, its equity tranches traded at 72 points, according to IHS Markit, much tighter than the 92 points of 0-15% tranches of CDX HY series 33, which has seen seven credit events.
CLOs face trading restrictions as bankruptcies mount
CLO managers could be handcuffed in impending bankruptcies if tranche downgrades continue and restricted trading periods kick in. Several bankruptcies have hampered CLO managers in the past two months, with $2 billion of US CLO collateral being hit. These bankruptcies include SpeedCast ($317 million of CLO exposure) and Ultra Petroleum ($277 million).
Restricted trading periods are triggered when there is a one sub-category downgrade of the triple A tranche or two rating categories for the double A, single A and triple B-rated tranches. At that point, a manager’s hands are tied in terms of being able to make trades such as bankruptcy exchanges, says Rich Reilly, New York-based partner at DLA Piper.
Managers have so far been able to trade out of credits that are likely to go into bankruptcy because tranche downgrades have not taken place to this extent. But when they do, “managers who haven’t made the right moves could find themselves handcuffed”, Reilly says.
CLO managers will also have to grapple with existing bankruptcies disrupted by covid-19, with cases being derailed due to limited exit financing access and little appetite for debt to equity swaps.
For example, VIP Cinema, a cinema seat manufacturer, filed for Chapter 11 in February with a prepackaged plan and a restructuring support agreement that would have reduced its debt. But in light of cinema closures during the covid-19 lockdown, lenders questioned the plan and terminated the agreement. VIP is now pursuing a liquidation.
Lenders have also terminated support agreements for EP Energy after its Chapter 11 filing.
Fund managers gear up for talf 2.0 investment potential
Institutional investors have been pouring money into the talf-focused (term ABS loan facility) funds, with ArrowMark, Loomis Sayles and Nuveen among the managers to benefit. US pension schemes have been attracted by the non-mark to market, non-recourse financing for three years on triple A assets with an extremely low risk of credit impairment.
“Given the historical performance of talf 1.0, there is already a blueprint for how this investment opportunity works,” says Justin Gregory, portfolio manager at Hildene Capital Management. “A lot of the uncertainty has been taken off the table in terms of execution.”
Some assets are more appealing than others under the talf programme, says Stamford-based Gregory. Credit cards and short duration auto loans, for instance, trade inside the cost of the underlying debt and are expected to be avoided by investors.
“Longer duration sub-prime auto triple As, student loan triple As and short duration CMBS triple As all trade inside 200 basis points, with attractive potential total return profiles assuming normalisation of spreads and an exit inside of the next three years,” says Gregory. “In a world where interest rates are at zero or negative, that’s still a compelling investment.”
Non-bank lenders spot fund financing opportunities
Volatility arising from the coronavirus will give non-bank lenders an opportunity to gain market share from traditional lenders in the fund financing space, sources say.
Insurance companies and specialty finance companies have different maturity spectrums, different funding costs and capital requirements compared to banks, says Khizer Ahmed, co-founder of Elm Ridge Advisors, a New York-based fund financing adviser. This means that they respond differently to dislocations.
Neuberger Berman Private Equity Limited, a closed end PE fund, moved its $200 million revolving line of credit from JP Morgan to Massachusetts Mutual Life Insurance Company in December. The facility was increased from an initial $200 million in December to $300 million in May. More transactions of this kind are expected.
Traditional lenders have slowed the pace of balance sheet deployment, sources say, and risk is being repriced, so borrowers can expect loan to value rates to fall. As a result, borrowers will have to provide greater equity cushions than before.
“We haven’t come across any instances where a lender has called an event of default with respect to valuation pressures around private capital portfolios,” says Ahmed.
Default cluster brings warning for recoveries and operations
The pace at which credit event auctions stacked up in May sent investors a strong warning to review default and recovery expectations, as well as to ensure operational readiness after years of benign markets.
At time of press, five credit event auctions were scheduled or completed in May, with the date of another — JC Penney — to be confirmed. Barring one for Ecuador, all hit the CDX HY index.
“It is likely the trajectory of corporate defaults hitting CDS indices will be much higher than in the global financial crisis,” says Dmitry Pugachevsky, director in research at Quantifi. “There are already seven defaults in CDX HY series 33, which rolled in September, whereas in HY 9 there were only six after 18 months.”
Credit event concentration makes it important to manage these very accurately, he adds. “Firstly, it should mean higher CDS payouts, as models of recovery tell us this is correlated,” says Pugachevsky. “And since we’re going from a low default environment, people may not have systems in place to navigate this clustering.”
Between each date, from default to trigger announcement, to auction, to recovery calculation and settlement, there could be big effects on portfolios, option strikes and base correlation, which investors might miss.
“The strike price of CDX HY options jumps from day to day based on defaults, sometimes without any market movement,” he says. “This means volatility measures can be completely off. We’ve found that ‘in the moneyness’ is much more stable and would be a better market standard. IHS Markit quotes this as well as price, but the market still runs on price.”
Libor fall weighs heavily on loan and CLO portfolios
Libor floors are set to return to prominence after three-month rates tumbled to 0.38% by 18 May, returning the loan market’s base rate to its lowest level since the oil and gas crisis of 2014-16.
Following the onset of the coronavirus pandemic, rate cuts by the Federal Reserve in March sent Libor plummeting below 1% for the first time in years, only to enjoy a bounce to almost 1.5% in April. For US broadly syndicated loans, 33.6% of the market has a Libor floor set at 1%, while 60% is floored at zero.
“In 2015 and 2016, 50 basis point Libor floors were common, and dicier credits could have 1% floors,” says Bishop Jordan, senior analyst at Eagle Asset Management, who adds that 50bp floors are set to gain in popularity when the new issue market reopens.
Middle market specialist Churchill Asset Management has a platform-wide requirement for loans with a 1% floor, which allows it to make incremental returns to equity investors when Libor falls below that level, according to David Heilbrunn, senior managing director and head of product development at the firm.
“Higher Libor is helpful from a marketing perspective in that it results in higher projected returns… but it also results in higher levels of interest burdens on borrowers, something which is certainly not needed in the current environment.”
Market participants are sceptical that negative Libor is likely. But if rates were to drop below zero, it would trigger floors on 70% of reinvesting CLOs. Another 18% of CLOs are unfloored, while 9% have floors on some tranches but not others, according to a Wells Fargo research paper.
RBC gets dressed for distress as it targets credit auctions
Royal Bank of Canada has emerged as a new entrant in the world of credit event auction bidding, a move that chimes with the bank’s recent push into distressed credit trading and suggests it sees a strong line of CDS settlement business in the coming months.
In May, the Americas Determinations Committee added RBC as a participating bidder for three CDS auctions in a row — Frontier Communications, Ecuador and Diamond Offshore Drilling. It had never before been a bidder in any auctions, according to the archive of auctions administrator Creditex.
RBC did not comment by time of press. But in April the bank hired New York-based distressed debt trader Jim Russo as a director from fund manager PointState Capital, where he worked for four years, according to web postings. And in May it added Callie Simpkins in New York as a director in leveraged finance sales. She previously worked at Goldman Sachs for eight years.
RBC is an arranger of CLOs, but priced just two new US deals in 2019, for Steele Creek Investment Management and PGIM.
Creditflux reported last month that the bank was working on a US CLO mandate for Zais Group.
Cure contributions come into play in CLOs amid pandemic
Some CLO investors are triggering a mechanism in their deals that lets them inject additional equity into structures to prevent them from failing over-collateralisation or interest coverage tests.
Known as ‘cure contribution’, the mechanism has featured in CLO documentation for years, but has only recently come into play as a result of the dislocation triggered by covid-19.
Panellists on Creditflux’s inaugural webinar on the US CLO market, which took place last month and was sponsored by DLA Piper, agreed that these features were being pursued in some instances.
Octagon Credit Investors portfolio manager Gretchen Lam said her firm had held discussions with equity investors, even though none of Octagon’s deals has failed an OC test to date.
“I think there’s a desire with certain investors to preserve the structure, and ensure that leverage and financing is preserved.”
Other panellists were sceptical of making contributions. “Just curing the OC test for one period is not really the right thing to do,” said Ujjaval Desai, portfolio manager at Sound Point Capital Management.
DLA Piper’s Rich Reilly highlighted that one of the most efficient ways of making a cure contribution is on a payment date (see page 10).
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