Share this report:
January 2021 | Issue 230
We were battered in 2020 — but we weren’t beaten
Hugh Minch
The CLO industry has survived a year blighted by covid-19. We talk to portfolio managers about the strengths of CLOs and preparations for what was expected to be a ‘cataclysmic’ recession
The first two months of 2020 were the final days of normality in the 2.0 era, and issuance largely kept pace with 2019. One change was the revision to the Volcker rule, first announced on 30 January, that would alter what CLOs could invest in from 1 October onwards.
A JP Morgan research paper from January identified the wave of refinancings taking place in the loan market in those months as a pressure on CLOs, which risked failing their weighted average spread test — a dynamic that would soon be irrelevant.
“We started the year with intense pressure on loan spreads, and a lot of repricing activity bringing spreads lower,” says Lauren Law, portfolio manager at Octagon Credit Investors in New York. “It was a huge headwind for the market.”
Most investors recall a moment where they realised the seriousness of the risk posed by the covid-19 pandemic. For DFG Investment Advisers’ co-chief investment officer Kashyap Arora, that date was 27 January, when his firm began putting on hedges in anticipation of what could come.
“Coincidentally, our founder and some of our colleagues happened to be in Asia, and the reaction they were getting from Asian investors was significantly different from what we were getting in the US,” Arora says. “This reinforced our thinking that there was a lot of complacency in the US market.”
“We started the year with intense pressure on loan spreads”
Lauren Law, Portfolio manager | Octagon Credit Investors
The initial sell-off in equities occurred around the time CLO market participants met in person for the first and (as it turned out) last time in 2020 at the SFIG conference in Las Vegas, where tight loan spreads and the large volume of CLO tranche refis still dominated conversation.
After China shut-down cities from late January, initial discussions on the economic impact of the coronavirus focused on the threat to companies that could trace their supply chains to that country, and then to Italy, which locked down on 9 March.
New York issued its stay-at-home order on 20 March, followed by the UK on 23 March, but many people had been working remotely for several weeks by then. Everyone spoken to by Creditflux for this report says the transition to remote working was surprisingly painless.
Index lows and triple A wides
In some ways, 23 March was the nadir of the crisis for CLO managers, with the S&P/LSTA Leveraged Loan Index bottoming out at 76.23 cents on the dollar, and 38% of loans trading below 80 cents. CLO triple As blew out to around 500 basis points over Libor and remained historically wide for weeks, retracing to an average of 362.35bp on 31 March, according to Prytania Solutions’ CLO index.
Loan mutual funds were forced sellers as they struggled to meet redemptions. Meanwhile, say sources, some CLO investors took the decision to sell CLO triple As as these were among the few assets that could fetch bids in the 90s.
“Every single day the market sentiment was moving depending on the news coming out from all over the world,” says Himani Trivedi, head of structured credit at Nuveen in San Francisco. “If you planned something out the day before on a name-by-name basis based on price levels, you’d have to re-evaluate the next day because everything moved so quickly.”
Peter Gleysteen, chief executive officer at AGL Credit Management, who is based in New York, says the first thing his team did after the pandemic struck was to pause investing for a few weeks. “Then we quickly reassessed everything we had invested in, and re-underwrote them using draconian downside assumptions, expecting a cataclysmic recession.”
Rapid central bank intervention
The response of fiscal and monetary policy makers to the crisis was swift and unprecedented in scale. The $2.2 trillion Cares Act, in addition to $700 billion quantitative easing from the US Federal Reserve, which had already cut rates to zero and launched a number of other programmes, combined to give CLO portfolio companies liquidity to keep the lights on.
“Before the fiscal and monetary support came in, people were hesitant to quantify what the pandemic meant for their portfolios because it was clear the government would have to intervene,” says Mike Pang, portfolio manager at Tetragon Credit Partners. “After it came through, we expected default rates would go up, troubled industries would remain troubled for some time, and recovery rates for the issuers that underwent default over the following months would likely be lower.”
“Secondary loan prices were deeply discounted, so we resumed investing”
Peter Gleysteen, Chief executive officer | AGL Credit Management
Issuance in the CLO primary market paused on 12 March — but the market did not stay closed for long. AGL Credit was one of the first companies to issue a CLO in April. “It turned out we were too conservative and the risk profile changes were not as serious as we thought, so we decided the vast majority of our investments were going to be fine,” says Gleysteen. “Meanwhile secondary loan prices were deeply discounted to fair value and new issue loans started coming out on very attractive terms, so we resumed investing.”
Gleysteen founded AGL in 2019, but his experienced team managed to grow the firm to become the single largest US issuer of CLOs amid covid-19, based on Creditflux data at time of press, with $3.13 billion priced across six new vehicles since March.
New CLOs welcomed by the market
“The primary market was shut but we opened the door and tiptoed out to see if we could do a CLO,” Gleysteen says, adding that although three CLOs preceded AGL’s deal, AGL Core CLO 4, they weren’t exactly comparable as one was static and another had one insurance company buy all the liabilities. “It turned out our CLO was strongly received, which we were pleased by because there was no guarantee that would be the case. Because it worked out so well we decided to do it again.”
Even as loan prices rebounded, the economic uncertainty surrounding the pandemic meant CLO managers were faced with the largest wave of rating agency downgrades in a decade. Around 60% of CLOs breached their triple C tests in April, around 13% failed junior over-collateralisation tests and, as a result, around 7% of reinvesting CLOs missed an equity payment. In July, 14% of reinvesting CLOs did not make an equity distribution, according to a Wells Fargo research paper that month.
Trump trumped by covid-19
Heading into 2020, market observers had expected the US election to be the primary macro event of the year. But with the pandemic overriding all other concerns, the lead-up to the election and subsequent results did not move the dial to the same extent as elections in the past.
Nevertheless, concerns around potential volatility through the election period caused nervousness among arranging banks, says Octagon’s Law.
“The loan market was victim of a strong technical where there was a large calendar of new issue loans that no arranger wanted to hold onto through the election period,” Law says. “So there was a large supply of new issuance in a short period during which CLOs were not exactly flush with cash, which put pressure on spreads leading up to the election”.
An optimistic ending for 2020
The final quarter of 2020 has been kind to CLOs. Rating agencies are upgrading loans from triple C faster than they are downgrading, deals that were breaching portfolio tests have slowly come back into compliance, and Libor floors are boosting excess spread, leading to higher equity distributions. The US election result is seen as positive for markets. And vaccine headlines signal the end of the pandemic is in sight.
“Now we’re asking which companies need a bridge to the other side”
Mike Pang, Portfolio manager | Tetragon Credit Partners
“With the news coming out of Pfizer, Moderna and others, and the recent approval of Pfizer’s vaccine by the UK, it’s no longer a question of will there be a vaccine, but a question of how quickly widespread vaccination happens,” says Tetragon’s Pang. “Now we’re asking which companies need a bridge to the other side and which companies have enough liquidity to stand that wait.”
With deal structures and pricing levels reverting to pre-pandemic norms, CLOs should benefit as the economy opens up through 2021. Meanwhile, Volcker amendments are on track to pass unscathed through the 60-day window in which they could be amended under the Congressional Review Act, meaning portfolio construction will be markedly more flexible in the years ahead.
Share this article:
Global credit funds & CLO's
January 2021
| Issue 230
Published in London & New York.
Copyright Creditflux. All rights reserved. Check our Privacy Policy and our Terms of Use.