One-year CSOs come to fore as investors predict widening

Dan Alderson

Deputy editor

With credit spreads entering the fourth quarter at much the same elevated levels they began Q3, investors are increasingly looking to bespoke tranches as a way of taking advantage while mitigating the market’s tail risks.

One-year CSOs in particular look attractive, since these allow greater selectivity in portfolios than index-based trades and provide comfort should spreads continue to trend wider. The customary tenor for bespokes has been two-to-three years.

“Credit looks historically cheap,” says Hubert Warzynski, portfolio manager at Ymer. The firm used CLO coupon payments coming due in July to redeploy into CSO equity from a portfolio of 100 names. And Warzynski believes the opportunity is there again, with further CLO coupon payments due in October.

“Short duration levered bets through CSOs minimise the risk of getting hit by mark-to-market,” he says. “It’s not clear we are yet at the extreme for credit spreads, but even if the market widens by 200-300bp it won’t hurt too much, providing there are few defaults. You get a great return without having to stretch and the pull to par is strong in a one-year trade.”

As Creditflux goes to press, newly on-the-run credit index iTraxx Crossover series 38 was trading at 647.5bp, while US high yield counterpart CDX HY series 38 — in the process of rolling into series 39 — was around 588bp, according to IHS Markit.

“You can achieve a 40% return on CSO equity”

Hubert Warzynski, Portfolio manager | Ymer

Crossover S37 was at 612bp, a comparable level to the 620bp it began at in Q3.

This implies the market is pricing in losses of 30% in the next five years.

“We wouldn’t put on a five-year trade in high yield index tranches,” says Warzynski. “But you can achieve a 40% return on bespoke equity maturing December 2023, while keeping to a tailored portfolio of companies with widest names only in the Lufthansa or Picard range.”

Picard one-year CDS was around 1,080bp at time of press, while Lufthansa was at 316bp. For Ymer, however, another advantage of bespokes is in being able to tailor the geographical mix.

“We are looking predominantly at the US — maybe 70% versus 30% European,” says Warzynski. “We will then most closely monitor the four or five in the portfolio we view as having greatest tail risks, which are across different sectors. At this duration, it is also easier to avoid refi risk and assess corporate balance sheets.”

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Global credit funds & CLO's

October 2022 | Issue 249

Published in London & New York.