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Opinion CLOs
Psychology was a factor in managers’ reluctance to sell out of First Brands
by Dagmara Michalczuk
Dagmara Michalczuk
Co-chief investment officer
Tetragon Credit Partners
We may overvalue what we already hold due to an emotional attachment
CLO managers today face a challenging environment of loan spread tightening and elevated restructurings/defaults. They also face a mercurial secondary loan market, apt to move on both news and rumour with unpredictable magnitude and consistency. Add high macro uncertainty, and the job of keeping CLOs invested in quality loans while generating healthy payments to equity holders becomes increasingly complex.
As investors we aim to be rational, but these testing times warrant a look at CLO manager decision-making through the lens of behavioural finance, which seeks to explain why investors may sometimes make sub-optimal decisions.
First Brands shows how managers act
The recent unravelling of First Brands provides a timely case study. As has been widely reported, the auto parts supplier’s failure to refinance its loans in August due to concerns about its use of off-balance sheet financing led to a precipitous fall in the price of its loans and an accelerated Chapter 11 filing.
According to an S&P report, the company’s sizeable working capital expenditures to fund pre-tariff inventory acquisition and the relocation of parts of its operations to North America also raised concerns for lenders and rating agencies. Additionally, the exit of certain Asian suppliers from the company’s supplier finance programme amplified worries about its liquidity.
In two weeks, its first lien loans plunged from the low-90s to mid-30s, with news of short positions in the company’s debt potentially accelerating the decline. In many ways, this price action was a classic example of a loss of confidence turning into a self-fulfilling prophecy.
Prior to its bankruptcy, First Brands’ first lien loans were rated B1 by Moody’s and B+ by S&P, with a spread of SOFR+500bps. In the context of the US loan index spread averaging around 320bps currently, this was a tempting high-income name with a strong rating. According to a Morgan Stanley report, around the time of these events, US CLOs held approximately 54% ($2.1bn) of the company’s first lien loans, while European CLOs held 81% (about €520m) of the Euro-denominated first lien.
On average, exposure was not outsized (at about 0.2% for both US and European CLOs) although deal concentrations varied widely. Closer analysis, however, reveals that certain managers sold the name as the situation evolved. This raises a question about their decision calculus. Why did some managers de-risk early, achieving higher exit prices, while others held on, with some opting to sell at lower prices later?
It’s important to remind ourselves that cashflow CLOs do not haircut or mark-to-market their underlying assets, except in the cases of defaults, excess triple C-rated holdings, or “discounted obligations” purchased below certain price thresholds.
As a result, CLO managers have little incentive to erode their deals’ overcollateralisation test cushions by realising losses without conviction that such sales will maximise recoveries. On the positive side, this allows managers time to assess and influence restructurings, which may improve recovery values. It also allows CLOs to be buyers of loans in dislocations. On the other hand, it may encourage managers to delay sales of underperforming assets, risking further price declines or the drying up of liquidity.
Of course, selling into a declining market is not always optimal as prices can subsequently reverse course. Managers must also consider deal-specific constraints and the size of their overall exposure to a credit when making sale decisions.
Understanding how we think
Behavioural finance suggests that for humans the pain of losing is psychologically stronger than the joy of winning. We may also overvalue what we already hold due to an emotional attachment (the endowment effect), potentially influenced by overconfidence in our skills and status quo biases. Our decisions may also be too greatly impacted by recent information (bad news in this case) or we maybe be anchored to historical information (ie, the loan was just trading at 95!).
In a credit market where it is increasingly difficult to distinguish between noise and signal, it is important for CLO investors to assess not only managers’ credit selection but also their risk management in distressed situations.
I would argue that credit teams that understand our human biases have a competitive advantage versus those that don’t.
