Market Wrap

Excess Spread — Caps off, repo time, CMBS but not

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

Welcome to the jungle

P&G SGR has made a bit of a noise about putting on a trade that’s probably a key route back for the CLO market in 2023 — leveraged senior tranche investing. It’s not an original idea, and there’s always some discussion in securitised products over whether senior notes with repo leverage are better value than mezz or junior with embedded structural leverage. But P&G has raised a closed end fund, Zoo5 (a tribute to the old Zoo CDOs managed by the firm) specifically to get this done.

It’s raised enough for a CLO portfolio of approx €60m, and could crank this up to €100m this year. So, small potatoes so far — the ticket size will have to be tiny to get a reasonably diversified portfolio — but indicative and interesting, we think.

Info so far suggests the repo leverage employed will be enough to crank up the E+200ish spread on senior tranches to double digit returns.

Senior CLO tranches should be an excellent item to repo, from first principles. Virtually no credit risk, floating rate, limited price risk…the main uncertainty is extension risk / repayment profile, which the repo counterparty doesn’t have to take. So the terms available, if the banks are open for business, should be decent.

More repo leverage in the mix does tend to create instability though. Repo lines can be pulled; repo exposure is generally opaque and hard to trace. It’s easy for one bank to build up large exposures; easy for a fund that’s the same way around on every position to get blown up by something like the LDI selloff (which was, of course, a repo blow-up in the Gilts market).

Admittedly that didn’t actually seem to happen in the securitisation market last October, but this could simply be because most triple-As in CLOs and consumer assets alike weren’t financed on repo.

Funds that take financial leverage down the stack tend to be highly conscious of the risks involved, the haircuts are conservative, and the high carry means there’s regular cash coming in for any margin payments that are required. At the top of the stack, the main investor base is bank treasuries, which are structurally levered by virtue of being a bank, and so more likely to buy and hold positions without additional repo leverage.

But look, at the end of the day, more capital coming into the sector, particularly into the triple-A, has to be a good thing for overall issuance. Plentiful repo provision is another way for investment banks to support the sector, beyond just buying triple-A notes in their own deals outright, and with triple-A notes still well the wrong side of 200 bps, every little helps.

Oh yes and people are still tweeting quite quite mad things about the CLO market.

Caps off

Rating agency notices between Christmas and New Year are not usually screaming must-reads, but our attention was caught by announcements that two Italian consumer ABS deals had reworked their hedging.

Bear with me! I think it’s quite important. The deals in question are Brignole CO 2021 and Brignole CQ 2022, two transactions sponsored by Creditis Servizi Finanziari, a lender owned by Chenavari Investment Management.

The loans backing these deals pay fixed and the notes, like almost all European ABS, are floating rate — so to protect the ability of the notes to stay covered if Euribor rose, it included an interest rate cap with a strike at 1.5%. In other words, if Euribor rose above this level, the hedging, provided by Natixis, would kick in and artificially maintain Euribor at the 1.5% level.

In times of flat, boring and usually negative Euribor, a cap was generally the preferred (cheaper) option for issuers — the counterparty got an upfront payment to enter into the transaction, but since the cap was well out of the money, it wasn’t expensive….it was basically a feature added to keep the rating agencies happy under various interest rate stress scenarios and improve deal structuring efficiency.

But, in case you’ve been living under a rock….interest rates have been rising! Quite a lot! One month Euribor is now through the strike rate, so the cap has kicked in — the issuers were both in the money based on the 1.5% rate.

One might reasonably question why Brignole 2022 and Brignole 2021 had exactly the same cap rate in place, given the different interest rate expectations at the respect times of issuance….but I guess that’s an indication that the caps were basically an artefact of the agencies.

Anyway, in late December, both caps were reworked into swaps…..and kind of flipped around. The issuers will pay a fixed swap rate of 1.5%, the previous cap level, and receive Euribor from Natixis. The caps were in the money, so the issuers could use part of this to fund entry into the swaps, with originator Creditis covering the rest of the cash.

This reworking has certain salutory effects on the ratings of the transactions — at DBRS, the Class X in the 2021 deal has had an upgrade from B to BB, the class D and X have been upgraded in the 2022 deal. Moody’s simply confirmed everything, while Fitch (which only rates the 2021 deal), stuck the class C, D and X on positive watch.

Fitch did say that “the new hedging structure is less effective than the cap, especially in Fitch’s decreasing interest rate scenarios because it erodes excess spread”.

It’s not clear from the release whether it was Natixis or Chenavari’s initiative behind the restructure.

Natixis may not have loved the increasingly large exposure to the Brignole vehicles from the caps, but Chenavari has no particular reason to let them out of it. On the other hand, it does own the class X in 2022 at least, which got an upgrade, presumably for good reason….

Anyway, the reason why we care is that we think there could be more of this activity coming down the tracks. The basic issue in securitisation last year was assets that pay (old) fixed rates trying to get financed at new floating rates, against a backdrop of Sonia and Euribor soaring.

That’s going to leave plenty of transactions (and plenty of cap and swap counterparties) with large exposures of some kind — and plenty of opportunities for restructuring these arrangements in the year ahead.

CMBS but not

How’s the European CMBS market doing? Pretty dead right? For a measure of the deadness, we think this loan, dubbed Project Raleigh, might be indicative. This rating slipped out on 30 December 2022 (otherwise we wouldn’t know about it!) and rarely have I ever seen a more obviously nailed-on CMBS candidate.

It’s a £141.9m loan from BNP Paribas to Blackstone, to fund the acquisition of a portfolio of urban logistics properties.

That in itself is indicative — in the dark days of 2020, Blackstone logistics deals were basically the entire European CMBS market. Logistics, at the time, was very much in vogue (we all did a lot of online shopping in the pandemic), and Blackstone appreciated the flexibility afforded by using the capital markets rather than bank debt only to fund its acquisition spree.

Other eminently securitisable elements in this loan include the size — large enough to be interesting, small enough to be suitably digested by sterling securitisation — the five year tenor, the package of interest rate hedging, the single-A rating (probably tranches nicely into an IG-only structure).

The spread, though, is probably a little lacking in juice for a capital markets exit, at 1.81%…..and we note from the rating report that the valuation on the portfolio dates from February 2022, so presumably this has been cooking for a while.

The loan may have been syndicated anyway, or potentially held over (obtaining a rating right before year-end might improve capital treatment on December 31, useful for a bank). But in happier times, this would surely have been a much-needed CMBS trade.


Tikehau Capital announced on Boxing Day that it had issued its inaugural $300m “collateralized fund obligation”, backed by interests in private debt funds which “notably include exposure to the firm’s flagship Direct Lending strategy and to its innovative Private Debt Secondaries strategy”.

CFOs are rare-ish (it’s not easy to get details on market size) but receiving more attention — there’s Financial Times piece here — and generally focus on stakes in private equity funds, rather than private debt. Tikehau’s release describes the deal as offering “an innovative access to private debt, an asset class with highly appealling features in terms of risk-adjusted returns in the current environment.”

Sure why not. Anyway, the basic purpose of the deals is to monetise stakes in funds up front. They can be issued by sponsors themselves, as in the case of Tikehau, or by fund LPs wanting to free up a bit of cash.

We wonder how the growth in this market is likely to interact with CLO supply.

The basic raw material of CLOs is CLO equity (see 9fin’s CLO Outlook for 2023 here), and for many brand-name institutions, that means their own capital or a specific risk retention fund. Tikehau, for instance, keeps its equity (and often buys its single-Bs as well).

So anything that raises capital for Tikehau (the new CFO adds $200m) opens up further opportunities to fund new CLOs.

Now, Tikehau is not especially short of cash…it’s listed, and per its last investor report, had €1.2bn of “short-term financial resources” at the end of June. Of course, staking CLO equity, especially if you are holding the risk retention as a horizontal strip, requires long-term financial resources. A more important caveat is probably that Tikehau has better potential uses of new capital than CLO equity at a time when expected returns are not looking good. As we’ve discussed fairly extensively round here, the case to issue CLOs right now is weak…..but it may not be weak forever.

But as the collateralized fund obligation market grows, and other alternative asset managers tap it to liquify their fund holdings….that’s still channelling more capital which can potentially be available for the asset class, if excess spread and expected equity returns bounce back.

Analysis of M&A and sponsor activity often focuses on the “dry powder” available to PE shops. Dry powder for CLOs is a combination of credit manager capital, risk retention funds, and third party equity investors. CFOs should help the first of these.

Risk transfer rush

The end of the calendar year might be low volume and slow for cash asset classes, but it’s peak time for risk transfer, as banks rush to complete transactions ahead of year-end balance sheet dates.

So we have a deal for mBank, an €800m portfolio, with CRC as the investor. We have Millennium BCP, with an SME and corporate deal, bought by three investors. We have an EIB and EIF deal for Santander Consumer Bank in Poland and another for Raiffeisen Romania.

That’s just the press releases…..notified so far on the ESMA Simple Transparent and Standardised website, as of Wednesday, were 11 STS synthetic deals in the month of December, with SMEs, large corporates, “others” and consumer lending as the reference asset classes. Five deals are unfunded (meaning they are likely to EIF/EIB or insurance deals) with the remainder funded transactions (meaning a more usual hedge fund counterparty).

Looking over the year in total, there’s a very healthy 41 STS synthetic deals notified, but the regulatory backdrop for the market is going to get tougher.

Afme (the Association for Financial Markets in Europe) reckons the “Standardised Approach Output Floor” would lead to bad news for large corporate and SME deals (the bulk of the market) being “severely negatively impacted, making them scarcely feasible”.

On Afme figures, 2021 saw enough risk transfer deals to free up capital for €80bn of lending, so this matters quite a lot. And the regulation is brutally complicated (it’s been a while since I’ve stared into the dark heart of securitisation capital requirements).

Basically, the “output floors” require a minimum level of capital — banks that use their own internal capital models can only reduce capital requirements by a limited amount compared to the capital required by a bank that doesn’t. The idea is to reduce the flexibility afforded by these internal models.

This operates on loan portfolios and on securitisation portfolios alike — but with different effects depending on the asset class. Since the basic operation of a synthetic securitisation is about changing a loan portfolio into a securitised portfolio and hanging on to the senior part, the relative effect is what matters, and what potentially shuts off corporate and SME securitisation.

Risk Control, which wrote the report for Afme, says: “In effect, the impact on securitisations is a ‘horse race’ between the increase in capital for on-balance-sheet loans and the capital increase for retained securitisation positions. How this ‘horse race’ turns out for a particular sub-category of loans depends crucially on the risk parameters of the loans involved, namely the [probability of default] and [loss given default].

A major part of the problem is the “P factor” in securitisations, which basically adds a little extra punishment to the European capital treatment in CRR. It’s supposed to account for “agency risk” in securitisations….but essentially it tips the “horse race” decisively against SRT securitisations of corporate and SME loans in this case.

The report is, uh, heavy duty, but if you want to pour yourself a strong coffee and dive in, it’s here.

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