Market Wrap

Excess Spread - CLOs break tighter, the CMBS iceberg, a local deal for local councils

Owen Sanderson's avatar
  1. Owen Sanderson
12 min read

CLOs — a floored product

The Euribor floor in CLOs has created all kinds of weirdness since rates first turned negative, turning a quintessentially floating rate product backed by floating rate collateral into, in practice, a fixed rate bond, while the market practice of quoting spreads without the floor benefit means CLOs yield considerably more than it seems at first glance.

CLO senior notes even attracted the attention of rates desks, usually unwilling to wade into the weeds of illiquid credit, with some realizing that the embedded Euribor floor was being undervalued in the CLO investor universe, and could be effectively sold out to the market for a profit.

The end-demand for Euribor floors comes partly from corporate treasurers - who need a Euribor floor hedge, because their loans also contain Euribor floors….which is the whole reason CLO tranches contain Euribor floors. So big picture, the trade was somewhat circular, but there was still money to be made intermediating it.

But medium and longer term rates have been rising in euros, cutting the value of the floor. On a coupon basis nothing much has changed — three-month Euribor is still around -55 bps, so the floor is still adding a huge chunk onto the headline senior spread — but this affects the term structure in CLO seniors.

According to Deutsche Bank’s research team, five year intrinsic Euribor floor values have fallen by 26 bps from around 41 bps at the end of August to 13 bps at the end of last week. The team noted that in shorter deals, the floor value has reduced but remains elevated, at around 40 bps in a two year bond.

The effect is compounded by the difficulty is assessing the actual life of a CLO tranche — as rates rise this may also push up credit spreads, and reduce the likelihood that deals with a two-year call will be reset early in the callable period — so four or five year reinvestment period deals may be more likely to actually run to that term rather than being called early.

With that backdrop, what to make of the recent break through the 100 bps barrier for CLO Triple A? Avoca XXV seniors came at 96 bps via Goldman on Wednesday, the reset of BlackRock X at 97 bps via BofA, and Blackstone’s Dunedin Park reset at 98 bps on Thursday.

We’ve heard reports that a Large West Coast Asset Manager (a recognised market euphemism) has been responding to the changes in the Euribor curve, keeping its recent senior CLO investments in the two year and below bucket.

But even if that’s the case, the continued tightening suggests there’s enough additional money coming into CLO seniors to counteract any particular investor’s reluctance to go longer because of the floor value.

The floor dynamics matter most in the senior tranche, where the Euribor floor makes up the largest portion of potential value, but another way to track the effects is to look at the AA tranches, where most managers choose to insert their fixed rate bonds. These prints underline the convergence, the fixed “premium” is coming down — the extra value embedded in the floater because of the floor is becoming less valuable, so the headline spreads of the two tranches are coming closer together.

On Wednesday, Avoca’s double-As came with a 15 bps spread — 175 bps / 1.9% — while BlackRock X managed 22 bps. Four days earlier, Albacore scored a 32 bps split. All these deals had similar 1.5-year non-call 4.5 year reinvestment structures.

A month or so earlier, Anchorage 5’s split was 30 bps, Carlyle 2021-2 was at 35 bps, and Blackstone and Cairn were both at 30 bps.

Rather than getting too cute about the floor (which may be less important for global investors buying on a currency-hedged basis) good old fashioned supply-demand technicals continue to dominate senior pricing.

Large Asian accounts, Japan-based and elsewhere, are said to be back looking at the market, while smaller non-anchor senior investors also have their buying boots on. The senior tranche tends to attract a small number of relatively large accounts — so spread tightening is acutely sensitive to technical factors. If a couple of €150m tickets are jockeying for position in a €250m tranche, they’re going to be a lot less sniffy about chasing it a couple of bps tighter than a few weeks ago.

But the tightening bias now on display ought to help the smaller guys more — arrangers are likely to recommend using the price tension available in a syndication, rather than relying on the certainty of an anchor, when spreads are heading lower. That means more bonds available, and maybe even….more liquidity in secondary.

The CMBS iceberg

Bank of America is marketing a UK CMBS deal, Taurus 2021-5, backed by student housing — specifically, by the loan which Blackstone used to buy out StudentIQ, a private sector UK student housing provider, in early 2020.

The interesting thing, to Excess Spread’s mind, is that the BofA portion of the loan is relatively tiny. The acquisition itself was a chunky £4.7bn deal, funded by £2.7bn of drawn debt, according to company records, split between a term loan and capex facility.

The major part of this debt was provided in a senior loan from Bank of America, Citi, Morgan Stanley and RBC (an existing lender to the business under its previous ownership), totalling £2.265bn of drawn debt, and secured on property worth £3.7bn.

But BofA’s CMBS exit is just £250m of the total — leaving an awful lot of UK student housing debt that must have found homes elsewhere. 

Before writing a £2.7bn cheque the banks will have thought about their exit (which, admittedly, may have looked different in February 2020), and the rest of the banking group have likely syndicated their exposures before now — leaving Bank of America bringing up the rear, the only bank to choose the CMBS route (or perhaps the only institution with sufficiently ‘diamond hands’ to hold student housing risk right through to the pandemic and into the new academic year).

You certainly see more CMBS exits emerging from King Edward Street than most other investment banks. In recent years, Taurus, the BofA shelf, has been by some way the most active CMBS programme in Europe. This issue is the fifth Taurus deal of the year, which doesn’t sound like a lot, unless you consider that last year saw six deals total across all of European CMBS.

I think we can assume that a big student housing loan probably wasn’t the most comfortable position to be holding through the pandemic, as universities shut in-person teaching, students languished at home (or demanded refunds of rent), and Covid ripped through halls of residence. Even now, in the new academic year, occupancy averages less than 80%, and is much lower in certain properties.

Looking at the company’s accounts, the facility breached its debt yield covenant in November last year, as occupancy of student housing plunged — trapping cash for the benefit of the secured debt, and required further support from Blackstone for the rest of the group.

Waiting, however, may have been the right move. Based on IPTs at the time of writing, the CMBS exit looks to achieve a blended cost in the low 200s, against a published senior debt yield of 4.6% — a nice trade if you don’t mind sitting on the position.

It’s lucky the other banks didn’t try their hand at CMBS, though, because a loan this size would have stressed sterling way beyond capacity, even without the pandemic impact.

The largest CMBS for more than two years was the £806m Taurus 2021-4 UK, a BofA/Blackstone deal this year mostly backed by logistics and light industrial property — an easier sell than student housing. Some of that deal also refinanced a 2020 deal, meaning investors may have happily rolled into the new issue, cutting the amount of true new money that needed to be placed.

The tiny CMBS portion in the StudentIQ financing, with most of the risk syndicated in loan format, effectively mirrors the role of CMBS in the broader European CRE market. 

Research from DWS suggests insurers have committed around €680bn to European real estate, with around 44% of life insurer exposures in private debt, and 18% of non-life. With European CMBS outstanding at around €33bn, that underlines the extent to which securitisation in CRE remains just a tiny tip on an enormous iceberg.

The big question, of course, is what does it take to change that? Answers, or wild speculation, to please.

Why you should actually care about “Article 8” CLOs

When people start talking about articles in European regulation, I tend to freeze up and glaze over, a trauma response which I think began around the time of “Article 122a”, the old pre-European Banking Authority risk retention rule.

So the quest for “Article 8 CLOs” proved a bit of a turn-off, despite my general enthusiasm for the ESG innovations striding through the CLO market. 

Naturally the person to remedy this lack of excitement was White & Case’s Chris McGarry, who has been a passionate advocate for ESG development in CLOs since well before it was cool, advising the G20 on the market.

“With over €3trn of financial products badged as Article 8 in the first few months of the SFDR and analysts predicting that more than half of total AUM in Europe will be Article 8 as soon as next year, the SFDR has paved the way for the largest shift in capital allocation ever seen,” said McGarry. “The SFDR has given certainty to the sustainable finance market and this constitutes a huge opportunity for CLOs to attract new investors to the market by opting for the Article 8 structure.”

“Article 8” is the EU’s “halfway house” or “light green” approach, under its Sustainable Finance Disclosure Regulation, allowing funds to be badged as “a fund which promotes, among other characteristics, environmental or social characteristics, or a combination of those characteristics, provided that the companies in which the investments are made follow good governance practices” — but does not require the heavy data burden required for an Article 9 “deep green” fund, defined as “a fund that has sustainable investment as its objective or a reduction in carbon emissions as its objective.”

This matters because it gives a definitive answer to the chin-stroking “what is ESG” question. “Whatever the EU says it is” might not be a perfect answer, but it’s good enough to attract capital, potentially channelling new investors into the CLO market, and creating tiering between managers which step up and meet the standard and those that do not.

Being an Article 8 fund requires a negative screen on ESG issues, which many European CLOs managers have already adopted, ditching assets like thermal coal, unconventional oil and gas, or munitions.

But it also mandates disclosure on adverse sustainability impacts across a portfolio — there’s a decent summary of the details from Deloitte here. Lots of CLO managers are already offering some ESG reporting to their investors, including sustainability scoring, but the data burden is quite a bit larger for a CLO looking to become an Article 8 fund itself — especially when a lot of the underlying assets are loans to privately held companies loathe to disclose even the most basic financial information.

CLO managers seeking this data, however, should be pushing at an open door. Larger leveraged borrowers may be caught by corporate-focused disclosure regulations, while sponsors themselves are increasingly trying to present their ESG credentials to their LPs, as well as their lenders. 

Lenders already send companies and arranging banks a bewildering variety of ESG questionnaires, prompting the European Leveraged Finance Association (ELFA) and the Loan Market Association to publish guidelines and templates in an attempt to standardise disclosures in this area. Pretty soon, it’s going to look embarrassing for any sizeable borrower to avoid offering lenders at least some useful ESG data. 

Once an Article 8 CLO comes to market (and it won’t be too far away), the big question will be, as ever, pricing — how much of the wall of Article 8 cash out there will come searching for compliant CLO paper to buy? And will that be enough to encourage managers to push through the extra disclosure challenges to comply with a non-mandatory regulation?

McGarry thinks so: “This is strictly voluntary for CLOs, but just as we see US managers that want to market deals in Europe voluntarily complying with aspects of the EU/UKSecuritisation Regulations, the wider audience attracted by an Article 8 deal creates the incentive for CLO managers and equity investors to opt-in.”

A local CMBS for local councils

We couldn’t help gawping at the apparent debacle at THG, the UK technology/protein powder/beauty products firm….to recap, the company’s capital markets day last Tuesday thoroughly bombed, wiping a third of THG’s market cap, and generating a flood of commentary in the UK press.

Monday morning brought a round of crisis-fighting from the group, with the founder, Matthew Moulding, giving up his “golden share” structure, and shares clawing back some of their decline.

But what caught our eye was the question of the company’s PropCo, ably dissected by Jamie Powell at the FT’s Alphaville. This was spun off ahead of the company’s IPO last year, and remains controlled by Moulding — who, thanks to a few neat tricks, managed to own the properties for very little money down.

According to THG’s 2020 annual report, this PropCo has “its own pool of securitised assets which enabled THG to leverage those assets and raise incremental capital to fund the next phase of property rollout capital investment for THG”.

We’re pretty sure there was no public UK CMBS backed by these assets, so went for a little explore. THG itself offers a little more detail on the transaction in its 2019 report, stating that the PropCo raised £197m of “secured debt and development funding” in the back end of 2019, highlighting elsewhere that Citi and CBRE acted on the transaction — in other words, not a real CMBS, but secured CRE lending.

The actual capital source is pretty interesting though — THG seems to have avoided commercial borrowing entirely for its PropCo, leaning heavily instead on local government . Trafford Council seems to have lent £70m for its new HQ (presumably the development finance leg of the trade), advised by CBRE, while Warrington Council lent the rest, which it reports as £151m. 

The £151m + £70m is clearly above the £197m reported debt, but the complexities multiply further — look through to the lending SPV and it looks like Warrington actually agreed to lend £202m.

There’s nothing especially wrong with councils lending money to real estate — I guess you could call it insider trading for the public benefit, and it’s probably better than doing derivatives speculation

But these are large positions. Trafford Council lent £153m for real estate development in 2019, a chunky (and controversial) sum — meaning the single THG loan was more than 45% of its annual CRE lending. Warrington, meanwhile, lent £283m last year, of which THG was 53%.

Whatever problems THG and Moulding are facing right now in public capital markets, at least they have the local council in their corner.

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