Global credit funds & CLO's
October 2020
| Issue 228
Published in London & New York.
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News in brief
October 2020 | Issue 228
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CLO-friendly workout language crosses Atlantic to Europe
European CLO managers are including workout language in new issue deal documentation that gives greater ability to participate in restructurings, according to market sources. The language was used in US CLOs earlier this year, as managers examine ways to close the recovery gap in restructurings.
GSO Capital Partners’ Deer Park is said to have been the first European deal to include the language, and several managers have followed suit.
“The language gives the manager a bit more flexibility, so they don’t get boxed out of a restructuring,” says Tyler Wallace, London-based portfolio manager at Fair Oaks Capital. “It’s likely this language will become standard in European CLOs.”
Banks employ tools to dig into CLO warehouse exposures
Credit analytics firm Oxane Partners has started a new business catering to the needs of CLO warehouse lenders, say officials at the company.
Banks have been monitoring their warehouse exposures since March when the coronavirus pandemic caused loan prices to plummet into the 70s. This triggered draw stops, causing warehouses to freeze until valuations rose.
Although warehouse structures have recovered, the episode has highlighted the need for banks to be able to examine their warehouse exposures on a deal-by-deal basis across their lending book.
Oxane says it has come up with a technology-driven solution and won mandates from banks looking to outsource warehouse monitoring. “We identified a gap in the market six months ago,” says chief sales and marketing officer Kanav Kalia.
“Our technology platform encompasses monitoring across facilities, on a facility and a loan level, and we provide back and middle-office support services,” he says. “It’s a complete solution: we integrate data from third parties, cleanse it, set up checks on covenant breaches and then provide a dashboard for banks to zoom in on any section of their warehouse lending book. It gives them better risk control over their overall positions.”
Methodology tweaks could prove a boost for CLO warfs
Moody’s proposed CLO methodology changes could impact 8% of US and European CLO tranches positively, the rating agency says.
Under the new proposal, obligors under ‘review for downgrade’ would be adjusted down by one notch, rather than the current two notches. In addition, Moody’s would not incorporate adjustments based on obligors under ‘negative outlook’ for weighted average rating factor (warf) purposes. It currently adjusts those obligors down by one notch.
The adjustments could see “warf figures stabilise or even improve and provide greater room for the manager where changes can be effected”, according to research by Deutsche Bank.
The bank says that “where the methodology change can be implemented in existing deals without controlling class consent needed, the possibility of upgrade exists if there are sufficient review for downgrade or negative outlook candidates”.
The warf rating scale assigns a value for the riskiness of CLO portfolios based on the rating of the underlying loans.
Moody’s has opened its proposal up to a request for comment.
Academic highlights 1.0 CLO inflationary practices
CLO managers during and after the 2008 financial crisis used discretion in reporting the fair value of defaulted assets or loans downgraded to triple C, and may have inflated these fair values, according to a research presentation at Creditflux’s CLO Symposium in September.
Florin Vasvari, professor of accounting at the London School of Economics, presented research detailing how CLOs that were close to failing their over-collateralisation tests in the 2008-13 period would report higher values for loans in default or in triple C buckets, relative to CLO managers holding the same loans, but which were not close to a breach.
In addition, Vasvari found that managers close to breaching an OC test would trade much more in the five-day period before reporting, and would trade significantly more between two CLOs that they managed themselves.
“This suggests that those trades might not be at arms length,” Vasvari said.
Sources say this trading behaviour has been stamped down on in the years following the crisis. One CLO manager, who asked to remain anonymous, said that they may have worked at an asset manager that moved loans between vehicles during the 1.0 era.
“Investors caught onto that and said ‘No’,” the manager said. “In most places, since the global financial crisis, there is a cross-trade policy using third-party pricing services that demonstrate fair value.”
Credit spreads wind back to February to bring shorts into focus
The credit rally since April has opened up an opportunity to go short credit, say fund managers, with spreads back to where they were in late February.
“We’re putting short positions on again,” says Geraud Charpin, portfolio manager at BlueBay Asset Management in London. “We had done so in February and I can’t justify going outright long today given fundamentals have deteriorated over the last few months.”
Charpin says he is not a fan of market neutral strategies, because they are like “sailing a boat without a sail. You always want to have a sail, whatever the state of the sea.”
As Creditflux goes to press, CDX NA IG is trading at 59.1 basis points. The last time the index was at this level was on 26 February, according to data from IHS Markit. It peaked at 150.8bp on 20 March.
Similarly, iTraxx Europe is trading at 61.6bp, its tightest point since 28 February and far removed from its 136.1bp peak on 17 March.
Charpin says: “Structural demand has driven the rally. A lot of retail trading accounts have opened and they tend to go long credit.” He is looking to position short high yield and long investment grade credit.
In February, Charpin had expressed his views by shorting bonds, but on this occasion he is amenable to going short via the credit indices.
Charpin: no lover of market-neutral strategies
European CLO leverage battered
Average leverage in European CLOs has dropped to 8.1 times debt to equity since April. The ratio was 10.8 times in the first quarter, following a gradual increase since 2017.
Fair Oaks Capital’s Fair Oaks Loan Funding II priced in May with the lowest leverage in recent years of 4.5 times debt-to-equity. Leverage levels in the first half of 2017 averaged 8.6 times, but since April, 18 out of 30 deals have priced with leverage below that level.
Palmer Square Capital Management’s 12.9-times-levered debut European CLO is the outlier; it priced in August as leverage picked up and is a static deal. It is in line with Palmer Square’s US static deals, which have priced with a 13.6-times average leverage this year.
One of the prime reasons for the increase in leverage in recent years was the restricted arbitrage for CLO equity. But since April, liability spreads for European triple A rated tranches have shot up to an average of 155.6 basis points for a three-year deal — 60.2bp wider than 4.5-year deals that priced in the first quarter of the year. This has necessitated a shift to lower leverage levels.
US CLOs have maintained an average of 10.5 turns of leverage in 2020. CBAM 2020-12 priced in July with a $6 million equity tranche and an astounding leverage of 78.7 times debt to equity. AGL’s ‘Core’ CLOs go to the other extreme with just two times debt to equity.
Leverage in European CLOs
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ESG index roll creates long and short opportunities
The first roll of a CDS index screening for environmental, social and governance criteria has opened a less-watched relative value opportunity for investors.
The iTraxx MSCI ESG Screened Europe index launched in June after a delay. It rolled in September, at the same time as other iTraxx indices, and added two constituents to the initial 81. The transition was less volatile than regular iTraxx Europe.
ESG Europe Series 34 (which follows iTraxx numbering) rolled at 46 basis points on 21 September, according to IHS Markit, but was 50.75bp at time of press.
Against this, Europe S34 widened from 57.75bp to 60.75bp. A bigger gap opened off-the-run, with ESG S33 at 45.75bp but Europe S33 widening from 55.5bp to 64.25bp.
ESG Europe has been thinly traded, with one or two dealers quoting at a 3bp bid/ask. But IHS Markit says multiple clients could use it to create ESG-screened structured products, such as credit linked notes.
“The high correlation with the underlying iTraxx Europe index is helpful as this will make it easier for dealers to provide exposure to those issuing products, while they can use the underlying index as a proxy hedge if needed,” says a spokesperson.
Moreover, LCH offers ESG Europe clearing, which IHS Markit says is unique for a CDS index within three months of launch and indicates strong market interest.
Banks are among the widest ESG Europe constituents, with new inclusion UniCredit at 164bp. Unibail-Rodamco-Westfield is widest in ESG Europe at 232.5bp, after fallen angels such as Deutsche Lufthansa and Rolls-Royce dropped from the Main basket for iTraxx Crossover.
Lagging CLO triple Bs draw investors into asset class
Senior US CLO spreads have retreated to their pre-pandemic levels, but triple and double B spreads have lagged — and those wider spreads are attracting new investors into the asset class.
Tracy Chen, portfolio manager at Brandywine Global, says her structured products team in Philadelphia is looking at CLO triple Bs in anticipation of spread tightening.
“We think that some CLO triple and double Bs are severely lagging other credit sectors,” says Chen. “Even if you are cautious on the credit fundamentals of the leveraged loan market, it doesn’t make sense that CLOs are underperforming loans by so much, because they have the same underlying fundamentals as the loans themselves.”
US CLO triple Bs average 436.21 basis points in secondary, according to Prytania Solutions’ PSL CLO index, while spreads for three-year reinvestment CLOs averaged 392.37bp in the primary market in the week before Creditflux went to press.
Chen says that high yield bonds have retraced 80% from their pre-covid level, but CLO triple Bs have only retraced 68% in the same period. Angel Oak Capital has also been increasing its allocation to CLOs, mostly in single As and triple Bs, and senior portfolio manager Berkin Kologlu says the focus is on secondary CLOs.
“Credit spreads will move tighter in this zero-rate world and we want to take advantage of that by buying discounted paper in the secondary space,” Kologlu says. He adds that Angel Oak has been buying middle market and bond-flex CLO paper.
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