Many, but not all, new CLOs issued since the start of October have included 5% buckets for bonds. Notably, some issuers elected not to add the flexibility into the documents of their new CLOs, likely fearing the prospect of wider debt costs printing into what has been a softer market. We wonder if this was a short-sighted decision, as the cost — a few incremental basis points — is modest when considering the potency of the broad investment universe eligible for inclusion in bond buckets.

Some CLOs issued prior to October had buckets that required the consent of the controlling class of creditors (typically the holder of the majority of the triple As). Implementing these buckets will take time and effort and many collateral managers are beginning that process.

When evaluating if bond buckets increase risk in CLOs, it is important to consider that they are set up in CLO documents as sub-buckets within the typical 7.5-10% ‘other than first lien loan’ bucket. If a CLO could already have 10% in securities other than first lien loans, using a portion of that allowance for bonds (which may include secured, first lien bonds) doesn’t generally add risk.

Furthermore, the increased flexibility of bond buckets should offer CLOs more tools to help combat the intra-creditor warfare in many restructurings, so it’s hard to see bond buckets as anything other than a credit-positive factor for CLOs.

To explore the potency of a small allocation to bonds, let’s look at a specific example. You may recall how several major US airlines pledged their frequent-flyer programmes as collateral to back new bonds and loans over the summer. In the case of Delta Air Lines, it pledged SkyMiles in a landmark $9 billion loan and bond offering.

The bonds and loans in the Delta financing share a pari passu first lien over the same collateral package, and they have comparable current coupons, maturities and ratings. The loan, of course, floats, so has the potential for rate-based upside, but also a 1% floor, protecting it from rate-based downside.

Despite the similarities, the prices of these two instruments have diverged sharply. The 4.75% coupon bond popped and trades around 104% today. The loan, also with a 4.75% minimum coupon, trades around 100.25%. If CLOs had bond flexibility when this deal was issued, a collateral manager could have bought the bond at new issue and then rotated into the loan over time as trading opportunities presented themselves. In the process, they would have realised a tidy gain, building par for the benefit of all investors. This trade alone would pay for a few basis points of wider debt costs. While there won’t be dozens of these opportunities each year, we expect there will be more than zero.