Market Wrap

Excess Spread — CLO v SRT, sell to strength, Lone Star lags

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

Too late

We cover loans BWICs on 9fin when they come up, and sometimes they can illuminate market dynamics.

We’ve no specific knowledge about the seller of the €91m list that was in market on Thursday, but it does have the smell of a partially filled CLO warehouse — mostly round lots between €2m and €5m, recent primary printed in the tougher times of the summer (888 HoldingsAffideaLa Liga), heavy on the favoured tech/healthcare sectors, nothing distressed (Upfield has been trading at pretty stressed levels but knocked it out the park in its Q2 numbers, prompting its SUNs to trade up 10 points).

The kind of stuff you might have picked if you were gently filling a warehouse during the illiquid summer months, in other words, carefully avoiding credits with limited pricing power, scooping up bargains when they appeared

If you had a partly filled warehouse with such names in place, you could crack on, try to print a term CLO, and then go pedal to the metal buying the rest of the portfolio….or you could survey the market and think, you know what? These bids are worth hitting. Depending on the timing of the purchases, there are probably some handsome gains to harvest in this list, while term CLO exits are still uncertain and expensive.

The last primary issue priced, Hayfin Emerald X, scored a 200 bps discount margin at the senior level, so nicely inside the 225 bps wides of the year, and is much firmer in the belly of the capital structure than the early August deals from Fidelity and Tikehau, but that was two weeks back. Cross has swung wider again since, and plenty of managers are keen to move deals in September, so investors can pick and choose and arrangers will struggle to push pricing.

Where it’s worth hanging on for the CLO or locking in gains depends in part on the difficulties of getting a deal to fully ramped status.

Lots of the primary LBO overhang has been dealt with somehow — direct lending, bank take-and-hold, dollars, deep discounts or a combination — and the lousy financing conditions have put the brakes on new M&A. That means little new money, in a market that’s been used to growing rapidly, and limited selling to make room for new issues. Refinancing has stopped dead, meaning less cash flowing back to loan funds, and less chance to reposition. Illiquidity also compounds itself; once it’s difficult to buy assets, managers are even less likely to sell the ones they do hold.

If some of the July/August rally was caused by the handful of new CLOs which priced, September presents the possibility of a savage technical squeeze on favourite CLO names.

Buying in the high 90s is all very well if CLO financing costs had rebounded to a similar extent, but they absolutely haven’t. Funding loans in the high 90s again means triple-As need to be back on the tight side of 150 bps, and they’re nowhere close…CLOs lagged in the initial selloff, and are lagging the rebound too. Flog the loans, book the gains, profusely apologise to your friendly local investment bank for the deal they will not be executing.

Or….buy cheaper assets. Bonds are still cheap to loans (but expensive to Crossover, go figure), so bigger bond buckets, as in Hayfin’s transaction, offer one way to make CLOs work. That comes with its own issues (basically rating agency treatment and hedging), which we discussed a little back in the spring, when scooping up cheap bonds was also a popular tactic. It helps, but it’s not a panacea — we haven’t seen the Hayfin doc, but the rush to bonds in the spring took the form of managers who’d historically run 10% bond buckets notching those up to maybe 15%.

That said, the obvious cheapness of CLO seniors has allowed broader distributions — a senior syndication in Hayfin, and Redding Ridge also looks to be distributing the tranche in its upcoming deal. Perhaps that’s because the traditional anchors are being particularly choosy, or uncompetitive, but anything that encourages a deeper more diverse investor base is probably good in the long term.

CLOs vs SRTs

Deutsche Bank priced a leveraged finance SRT deal this week, LOFT 2022, the first such transaction from the German bank since 2018.

Depending on who you ask and how you define it, LevFin SRTs are either common as muck or surprisingly rare — several of the well-established SRT-issuing European banks mix some of their RCF exposures to leveraged issuers into their large corporates deals, for basically the same reason as they try to get rid of RCF exposure generally. It costs a lot of capital, it’s generally not drawn, and needs to stay on balance sheet for relationship reasons.

Somewhat rarer are deals referencing purely leveraged finance exposures — for one thing, in a normal year, banks tend to move a lot of this risk rather than store it, and even in 2022 there’s little point in doing, say, a five year hedging transaction just to reduce risk on a few hung primary transactions. Banks mostly do keep their revolvers, but these are kept to a minimum in LBO structures.

Bank of Ireland has printed a couple of deals called Mespil, referencing its mid-market leveraged and acquisition finance book, but these are naturally more granular than the kind of LevFin book you’d expect from a bank like Deutsche. BMO has also reportedly set up a programme, while other banks, both US and European, are said to be discussing transactions.

The Deutsche deal apparently references a $2bn portfolio across Europe and the US, and priced at SOFR+1900 bps for the most junior tranche, +750 bps on the junior mezz, and +600 bps on the senior mezz, for a blended 1320 bps across the $380m of issued notes. Structured Credit Investor cites the tranche thicknesses as 0%-10%, 10%-14% and 14%-19% respectively on the three tranches, which illustrates some of the difficulties in doing LevFin SRTs — that’s a pretty fat slice of risk to sell.

For comparison (there’s a handy rating for me to look at), in Barclays’ Colonnade Global 2018-5, a large corporate deal, the risk transfer tranche is 0-8.8%.

So is LOFT expensive for Deutsche? If you assume loans at 500 bps, it’s paying more than half the portfolio spread away in protection. If it’s full of undrawn RCFs, probably much more.

Leveraged finance actually defaults in meaningful proportion (Fitch expects 3% for 2023), so you need thick tranches to make a deal work, and investors need to be compensated for eating these losses.

That said, the headline default rates are probably not a good proxy for the DB transaction. If it is full of revolvers, these tend to suffer less than institutional debt in a restructuring situation, even if they’re theoretically both pari. Sponsors are less likely to hose their relationship lenders than a bunch of random institutional accounts; they might not even have drawn the RCF when they start restructuring negotiations.

The Deutsche deal is also likely to feature the better end of leveraged credit — as one SRT investor put it, “the first thing we do when we see a LevFin SRT deal is look at the trading levels on the outstanding loans. If it’s below 97, we toss it.”

That attitude is unlikely to have won many transactions in 2022, but the basic point stands — it’s going to be a disclosed pool marketed to investors with corporate credit expertise. One would presume the investors would remove perennial basket cases or possible restructuring candidates.

The other question is, how much does this risk cost in the cash market? It’s not exactly comparable — cash CLOs get the benefits of excess spread in the structure so they should trade tighter, and equity has far more optionality. Unlike SRT, though, equity has to take the risk of seeing distributions switched off.

CLO equity distributions are running at 15.3% for EU and 13.3% for US, according to Barclays research, so 19%, as in the Deutsche deal, doesn’t look too far off the map (CLO equity prices can be all over the place but are unlikely to be anywhere near par). Par subs in recent deals have been tracking towards 10% on the single B, so it’s roughly comparable to the 0-10% tranche thickness in LOFT 2022.

But the mezz on the SRT trade looks much better for the issuer — 750 bps for a 10-14% tranche, vs 1100 bps (US) or 1272 bps (EU). Single Bs in cash deals are more like 9-12% tranches, so should come wider….but that much?

Double B is a similar story, at 600bp for 14-19% in the Deutsche deal, vs generic levels of 867 bps and 870 bps (US and EU) for 14-18%ish in the cash market….

All numbers are back of an envelope approximates, except the generic spreads, sourced from the excellent folks at Prytania Solutions…..but there’s definitely a picture emerging.

SRT deal pricing has been holding in remarkably well all year compared to the cash CLO market, helped by the existence (and successful fundraising activity) of several dedicated players.

The seasonality of the market has probably helped pricing to an extent — because SRT trades generally improve the look of bank balance sheets, they’re generally executed just before the H1 and FY balance sheet dates, meaning in late June or December. The December peak is larger, with the widest range of possible deals to do….but if you’ve raised a fund early in the year, how do you tell your LPs you’re going to sit on the money until Christmas?

Several funds do look at both markets, and will have seen better value in bottom fishing in the cash market this year….but the SRT-dedicated funds make this an attractive relative value option for banks looking to sell on their LevFin risk.

For certain European institutions, there’s an additional motivator, in the shape of a strongly worded letter from Andrea Enria, head of the ECB’s bank supervisory arm, sent to all “signficant institution” chief executives in March.

“The ECB has identified a number of significant deficiencies in banks’ risk management practices. In many cases, risk management is inadequate and not well-developed enough given the high-risk strategies pursued…..The ECB has also identified severe deficiencies regarding the management of risks arising from underwriting and syndication activity [ECB’s emphasis].

Given the generally dry tone of regulatory communication, this is brutal, and banks will have had to take notice.

The ECB possibly didn’t have “do more SRT” in mind when it sent the letter, but a successfully placed SRT trade serves as a market validation for banks’ risk management. It’s a third party real-world price for portfolio risk, without the inconvenience of actually selling the portfolio in question.

Kensington calls

Of course Finsbury Square 2019-2 and Gemgarto 2018-1 were going to be called. Kensington itself has a spotless record of honouring first optional redemption dates (FORDs) in the modern era; Pimco, which is acquiring the Kensington back book, has a slightly more mixed record, with some skipped calls in 2021.

But on past performance, Pimco will want the mortgages locked inside the various Kensington securitisations on an unlevered basis, as with the UK Asset Resolution portfolios it purchased, so it’s going to have to call deals as they come due.

Past performance is no guarantee of future, but Pimco’s typical pattern with the UKAR portfolios is to turn its portfolios into wholly owned securitisations, paying an investment bank for the risk retention, and buying and holding all of the securitisation tranches across the various pockets of its Income Fund complex.

An institution as massive as Pimco has plenty of other pockets it can put back book assets in — the Disco and Bravo fund complexes have bought tons of consumer credit risk over the years, in various states of distress — but Kensington’s mortgage book is decent quality performing secured lending, and is unlikely to generate PE-style returns without a lot of leverage in place.

We mention these calls not because they’re surprising, but because it’s as good a time as any to pour one out for the gradual disappearance of the largest RMBS issuer from the European market. Kensington is a benchmark, a pathfinder, a flag-flyer for the UK specialist lending sector; even its competitors regret the likely end of its RMBS activities.

There is, however, a small slice of Kensington collateral out there in market at the moment, in the shape of the Goldman Sachs-sponsored Parkmore Point RMBS 2022-1, a rare UK reperforming loan deal backed by £267m of deeply legacy mortgage collateral — the portfolio has 16 years of seasoning but has paid down to just 98% of the original balance, with arrears capitalisation balancing out any actual principal payments that were made.

It’s quite a punchy transaction to lead out a market reopening for the autumn session, especially with the looming cost of living crunch in the UK — some other collateral highlights include 57% self-employed, 30% with 1 or more county court judgment, 65% self-cert income. These are definitely complex borrowers for incoming servicer Pepper to take on. But the epic seasoning probably softens the blow a little…..does it really matter what income statement a borrower provided 16 years ago, if you know their payment history since then?

Anyway, one presumes Goldman know what they’re doing, and have a line of sight to where these bonds will land. If this can get done, any other mortgage trade should be fine.

While the Kensington redemptions weren’t in doubt, we’d missed over the summer that the Lone Star-sponsored European Residential Loan Securitisation 2019-NPL1 (ERLS 2019-NPL1) deal had gone through its FORD, the only deal missing its call this year.

The structure is a piece of equity-friendly Morgan Stanley artistry, with tiny stepups (actually, none at all on the class C), deferrable interest on the B and C notes, and a mechanic to allow excess sale proceeds to flow to equity. But it has at least paid down a fair bit, with the class A down to 0.51 factor at the last payment date, and class A credit enhancement up above 70%, so at some point it will be more efficient to refinance.

Barclays, anyway, says chill, in a research note saying that “Extension risk is not material” — it suggests that a joint refi with ERLS 2019-NPL2 in November could be on the cards. There’s also a couple of Cerberus refis to get through before then, Towd Point Auburn 13 and Vantage 2, which Barclays expects to be fine “on the basis that Towd Point Mortgage Funding was able to refinance an Auburn deal in February 2020 when the market was just starting to become more volatile”.

Not totally sure about that rationale myself, but it’s worth noting the Cerberus-owned CHL restarted front book lending last year, and has been expanding its range of buy-to-let offerings this year — so keeping securitisation investors sweet should be top of mind.

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