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Managers find multiple uses for bond buckets and begin pushing for greater flexibility
by Lisa Lee
Years ago, US regulators changed rules that prevented CLOs from holding bonds. Now managers are slowly taking advantage.
For the first time since the Great Financial Crisis, the US CLO market has crossed the 5% Rubicon for bond bucket limits. The average US CLO bond bucket has risen to 5.08% this year from just 0.32% in 2019, according to figures from Dealscribe. Bank of America research estimates that US BSL CLOs have purchased USD 2.3bn of high-yield or investment-grade bonds in 2024.
“There’s been increased usage in the primary market, as a means of reducing the initial purchase price in order to make the equity arbitrage math work. But there’s also been, over time, increased exposure being built into existing portfolios in deals that have permitted allowances,” said Dagmara Michalczuk, co-chief investment officer at Tetragon Credit Partners.
In the CLO 1.0 era, most CLOs had the ability to construct portfolios with bonds. All that changed when the Volcker Rule came into effect in 2015. The post-GFC regulation prevented banks from buying securitised products that held anything besides loans. The CLO market responded by getting rid of almost all bond holdings.
Average US CLO bond limits by vintage
Source: Dealscribe
Even after US regulators decided in 2020 that the Volcker Rule did not apply to CLOs, managers remained wary of bonds. The market was content with 5% maximum bond buckets, and they weren’t much used. But rising inflation and hiked interest rates have changed that.
There are multiple reasons to buy bonds. Some managers see the potential for bond prices to spike higher if and when the Federal Reserve cuts interest rates. Others prefer the safety of investment grade bonds or a high-rated junk bond to a triple C rated loan.
“CLO managers differ in terms of how they use their bond buckets. Some use them for offensive purposes and some for defence. Managers who utilise the buckets for offense tend to buy wider spread credits on hopes of tightening,” said Scott Macklin, head of US leveraged finance at Obra Capital.
“We think it makes more sense to use the buckets for defence – offsetting sales of stressed loans and as a portfolio hedge against slowing growth. We also think it makes sense to purchase same capital senior secured bonds as swaps for loans already owned when those bonds traded materially wide to the loans.”
Either way, there are downsides to owning bonds. Unsecured high-yield bonds can have low recoveries in the event of default. Safer bonds offer lower coupons than triple C loans, dampening cashflow to equity investors. And in a higher-for-longer environment, anticipated bond price appreciation may not materialise.
Still, Brigade has nabbed a 7.5% bond bucket deal, as has Zais. Irradiant has gone a step further, with a 15% bond bucket. In many of these cases, the CLO manager is seen to have expertise in bonds, with some even issuing modern-day CBOs, according to market sources.
“Brigade has pushed for a higher bond bucket in our deals because, for experienced bond investors like us, it is a valuable tool,” said Justin Pauley of Brigade. “We have used the bond bucket to reduce credit risk by swapping out of lower dollar stressed loans into IG bonds at similar dollar prices. In exchange for this additional flexibility, we typically have smaller buckets for second-lien loans, which we view as higher risk and less appropriate for levered, rating-sensitive funds like CLOs.”
Some managers are now seeking larger bond buckets, only to be pushed back, according to market sources. One recently asked for a 10% bond bucket limit that was cut to 5%.
“I don’t see US bond buckets increasing much beyond the standard levels, as I think there would be pushback from equity investors and from mezz investors,” said Michalczuk.
