Global credit funds & CLO's
November 2020 | Issue 229
Published in London & New York.
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Opinion CLOs
Thomas Majewski
Thomas Majewski headshot
The cost — a few basis points — is modest compared to the potency of bond buckets
Founder & managing partner Eagle Point Credit Management
November 2020 | Issue 229
As of 1 October, the criteria for securitisations, including CLOs, to not be considered ‘covered funds’ under the Volcker rule became a little easier. Amendments to the Volcker rule drafted by congress and commented on by market participants earlier this year took effect last month. Volcker relief is here for CLOs (almost).
Certain CLOs issued prior to October had automatic provisions for springing bond buckets. Those buckets are now open for business and we expect to see evidence of collateral managers beginning to prudently use this flexibility in October and November trustee reports.
Issuers shouldn’t worry about costs
There is one possible headwind against broad implementation of bond buckets — The Congressional Review Act. This law, enacted in 1996, provides that congress can effectively undo certain rules provided by regulators within 60 session days of their coming into effect. So while the effective date has passed, some are advising to stay on the sidelines until the review period ends. Hopefully though, congress’s attention is focused on passing the next stimulus package, rather than undoing Volcker rule changes.
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If CLOs had bond buckets when Delta Air Lines issued debt, a manager could have bought the bond then rotated into the loan
Congress could still make hole in buckets
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.
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