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News in brief
June 2021 | Issue 235
Lupus Alpha CLO funds bounce over 100% in year-long rise
Lupus Alpha’s CLO funds have posted 100%-plus returns in the past 12 months, with Lupus Alpha CLO Opportunity Notes II up 137.24%.
The manager’s European CLO fund was down 52.9% in March 2020, but its recovery peaked in May and June when it posted gains of 15.58% and 22.77%, respectively. It ended the year flat, but is up 24.33% in 2021.
Lupus Alpha CLO Opportunity Notes I has taken a similar path, gaining 100.88% in 12 months. It lost 38.77% in March 2020 but ended the year up 16.08%.
CLO funds dominated the Creditflux performance charts in April.
US CLO managers with eye on Europe opt for risk retention
The US CLO market celebrated as domestic risk retention requirements were overturned in February 2018, but issuers are increasingly taking down 5% of their CLOs voluntarily with a view to satisfying European risk retention rules.
Taking financing against a vertical strip running across a CLO’s capital structure has been a popular tactic for US CLO managers this year. Officials at Nearwater Capital, a firm which specialises in risk retention financing across global structured credit markets, say they have financed close to 30 CLOs globally in 2021, up over 100% on 2020.
Jonathan Kitei, Nearwater’s head of risk retention financing in New York, says US CLO managers abide by European rules because they are then able to access additional debt and equity investors.
“Having access to a larger group of investors can lead to better terms and overall better deal execution,” he says. “We have recently provided financing to a number of US CLO managers whom we expect will make this a regular part of their issuance strategy.”
Years ago, there were only a handful of investors based in Europe that needed risk retention compliance in order to allocate to US CLOs, but that has broadened out. In addition, says Kitei, there are CLO investors in the US that have pockets of capital that must comply with EU/UK risk retention.
Ballyrock CLO 16 is an example of how European risk retention compliance can lower financing costs. The CLO priced on 17 May via Bank of America with triple A notes paying 115 basis points. The print was 3.2bp tight of the 10-day rolling average and the manager, Fidelity, has not been a prolific issuer.
CLO managers syndicate equity as arb is finally attractive
Some US CLO managers have forgone majority equity holders in the past month, opting instead to syndicate first-loss tranches to between four and six investors.
Sources say the trend has emerged in part because the CLO arbitrage is at the most attractive level it has been since 2018, when liability spreads hit their cycle tights following the 2008 crisis.
Numerous investors have raised money to put into CLO equity and are ready to bid at attractive entry levels.
CLO managers can get a higher fee rate by opting for syndicated equity tranches over a majority investor. However, some managers prefer to anchor their deals because it provides certainty during the warehouse stage that the majority equity will backstop the transaction if it has difficulty printing.
Equity investors have told Creditflux that risk-adjusted yields on CLO equity are modelling out to be between 2% and 3% higher than for deals issued pre-pandemic in late 2019 and early 2020.
Many point out that the asset class has proven itself a reliable performer through two crises.
However, tiering between managers has widened based on performance through the covid-19 pandemic.
Direct lending newcomers reveal doubts over losses
Large direct lenders are quick to point out that experience and restructuring experience counts, particularly as we enter a default phase.
What’s surprising is that, when it comes to capital markets investors, those new to direct lending doubt their own ability to manage losses. Such investors typically align themselves with large fund managers.
Ocorian surveyed 100 capital markets officials globally from mid or large-cap banks or private capital businesses with balance sheets of $50 billion to $1 trillion.
The report found that, although direct lending is popular, 47% lack confidence in their ability to manage loss recoveries, especially if they have been operational in direct lending for less than five years.
But there are reasons to be bullish, with 90% of respondents to Ocorian’s survey portraying confidence in their ability to take security.
The survey underlines how mainstream direct lending has become, with 87% of capital market investors pursuing the strategy. Of those that are not, just 1% say they are not planning on allocating to this market.
European CLO managers bake in triple C flexibility
Three European CLO managers are understood to have embedded language in post-covid CLO documentation that affords them flexibility in managing triple Cs, according to market sources.
Angelo Gordon, CSAM and PGIM are said to be among those which have included stipulations whereby if an asset was not triple C-rated at the time of purchase, but is downgraded, it does not feed into the deal’s 7.5% triple C limit.
In a typical European CLO, managers need to satisfy, maintain or improve triple C ratios during the reinvestment period, otherwise trading is restricted.
The new language does not affect a CLO’s over-collateralisation ratio. Also, it does not promote the retention of large numbers of triple C loans because of the impact this would have on other metrics, such as the weighted average rating factor test.
Sources say the language is aimed at giving managers flexibility for credits downgraded to triple C, which have a clear path to recovery. Holland & Barrett, for example, was downgraded last year, and has now been upgraded by Fitch, Moody’s and S&P.
One CLO investor says the language will be useful during mass downgrades such as the March sell-off last year. “When people first hear of it, they say it’s terrible but it’s not affecting the OC ratio,” says another source. “Investors would only say yes to managers who are good at credit selection.”
CLO managers generally are being afforded more flexibility, with loss mitigation loans another area where handcuffs have been loosened so managers can acquire certain obligations in connection with a default or restructuring.
Equity tranche longs fall out of favour as spreads tighten and dispersion picks up after uniform moves
Dispersion is picking up after relatively uniform moves in credit in the early part of 2021. CDS index equity tranches had outperformed for much of this year but spreads have gapped out a touch in the past few weeks.
The 0-3% tranche on iTraxx Europe printed at 29.05 points upfront on 29 January, but tightened to 23.44 points on 16 April. Since then, it has drifted out to 25.3 points up front. Base correlation has dropped to 50bp having been at 53bp for the first four months of the year.
Other CDS equity tranches have followed a similar path, although CDX IG 0-3% has only widened narrowly, from 29.82 points to 30.73 points in May.
Investors say CDS equity tranches have been the outperformer this year, with a decrease in dispersion and compression of lower-tier credit boosting equity and junior mezzanine tranches.
But several fund managers thought the trade had run its course and told Creditflux they were looking to unwind.
Kelley Baum, head of credit derivatives at III Capital Management, wrote in her Creditflux column in April that a short position in CDX HY equity versus delta could profit as dispersion and defaults pick up.
She said that about one-and-half defaults per year would be needed to break even on the trade, with HY default projections at 2-3%.
Breakthroughs come thick and fast for Libor alternatives
Momentum has gathered around initiatives to replace Libor in contracts, with CME Group obtaining a regulatory nod on the term Secured Overnight Financing Rate (Sofr) as well as moving to launch interest rate futures based on banks’ short term credit yields.
On 21 May the Alternative Reference Rates Committee (ARRC) named CME as administrator of term Sofr. Days later, CME said futures based on the Bloomberg Short-Term Bank Yield Index (BSBY) would begin trading in the third quarter.
“The BSBY futures launch will build on our launch of Sofr term rates,” says Agha Mirza, global head of interest rate products at CME, who believes both developments have useful attributes.
The Loan Syndications & Trading Association (LSTA) hailed the ARRC decision, saying loan market participants now “know exactly what term Sofr will look like once recommended”.
Covid-19 related volatility from March last year illustrated the gap that can arise with assets and liabilities if market participants use only Sofr as their Libor replacement. US dollar Libor, which embeds a bank credit component, will tend to widen in times of stress whereas Sofr, which is based on secured repo transactions, will tighten.
“BSBY futures arose from our discussions with clients that have a demand for credit sensitive instruments, such as US regional banks and global banks based in the US that prefer to use a forward rate with a credit component,” says Mirza.
BSBY is a proprietary index measuring the average yields at which large global banks access US dollar senior unsecured marginal wholesale funding.
Focus shifts to macro views amid blurry relative value picture
Relative value trading has become a difficult place to operate in credit, with previously effective strategies such as compression, pairs and basis hard to discern and opportunities difficult to source, according to portfolio managers. Instead, most trades must begin with a macro view followed by overlaying specific name by name analysis, they say.
Volatility has abated, but value has also been squeezed from the picture. The consensus among Creditflux sources is that the ‘Goldilocks’ environment favours equity and next generation alternative returns over credit.
Spreads are anchored close to the tights but look set to ebb wider over the year as concerns about inflation and central bank policy take hold while economies reopen thanks to vaccination rollouts.
“Everywhere we see very long positioning, with investors forced to buy credit and rates — all the while not knowing if the rhetoric on inflation is right,” says one PM in London.
Another PM dubbed iTraxx Crossover (at 252.5bp according to IHS Markit at time of press) a “clear protection buy” for those who can afford the carry.
But big questions remain unanswered about whether inflationary factors — such as supply bottlenecks and geopolitical risk — will be temporary or permanent.
“The challenge is to create balanced portfolios that contain yielding assets but also those that position defensively and can lower the overall volatility, even if they also curb returns.”
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Global credit funds & CLO's
June 2021 | Issue 235
Published in London & New York.
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