Market Wrap

Excess Spread — Dip buyer in chief, sunscreen at night, the treasury edge

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

Something old, something new, something borrowed, something blue

The CLO primary market shouldn’t really exist at the moment, as we’ve remarked on a number of occasions. And yet the deals continue to come. This week has brought Neuberger Berman (blue logo), Oaktree and CQS (something new) to market; Ares and KKR Credit are marketing, Tikehau has been announced, while last week brought Barings (something old).

Other transactions in market include Onex, CVC (absent the much-discussed NoChu) and WhiteStar Asset Management.

CQS is particularly noteworthy, as Grosvenor Place 2022-1 is in effect a debut transaction — the last deal from Sir Michael Hintze’s hedge fund was Grosvenor Place 2015-1, a transaction which, as the name suggests, is pretty long in the tooth (it was reset in 2017).

The firm has an extensive CLO investing operation, but CLO management has been relaunched much more recently. It has a partnership with Jefferies for CLO equity in the US, but no such arrangement is disclosed over here (it’s bringing its own firm capital to the new European deal), possibly via a vehicle called CQS Loan Funding, incorporated in May. The new issue came with maximum ESG bells and whistles, including “Article 8 alignment”, and presumably the shelf will continue down this line.

When CQS restarted the CLO management platform, it probably wasn’t looking to do a deal with a one year reinvestment period and one year non-call — a quick punt on loan recovery — but that’s the reality of today’s market (Barings and Cross Ocean presumably weren’t thrilled with the 1/1 structure either).

Debut CLO deals are particularly hard to do, since the manager has no track record or known style to refer to — and investors may also worry about access to collateral, relationships with sponsors, resourcing, and the longevity of the platform in question. The only other debut this year has been Acer Tree’s Logiclane I back in January….which was a new shop with a long pedigree, being co-founded by Jonathan Bowers, who launched CVC’s credit platform.

There’s no shortage of aspiring debutants, with Fortress, M&G, Pimco, Signal Capital Partners, Pemberton also exploring a launch….but the market is tough enough even for managers with double-digit deal counts outstanding, so it’s doubly difficult for the debutants.

Anyway, put all this dealflow together and it’s the same sort of collective irrationality that gripped the market in the summer months — for any individual manager looking to stack up some AUM, it’s rational to come and print, for the market as a whole it’s squeezing loan prices and making it harder for deals to perform.

Managers have been bringing low-ramped transactions — Oaktree had a portfolio of around €70m or so, bought at an average price of 97ish (ouch) much of the potential deal performance depends on buying the other €330m at bargain basement levels. There’s not enough spread in the deals from loan margins; principal appreciation is the only game in town.

Even without the technical squeeze from pricing CLOs, this could be a forlorn hope.

“You have to ask yourself whether you're going to get a cheap entry point?” said Simon Gold, a CLO investor at Chenavari. “In crises like Covid or the GFC there was real dislocation. This is effectively just a normal credit downturn, so assets that are cheap are mostly cheap for a reason — so there's less reason to hold cash in the hope of benefitting buying 'cheap' loans than in previous shocks”

What could bring the market back into balance? The obvious answer is loan supply, but there’s precious little around. The only loan issue this week has been Ineos, a refi, not a new money deal….and one where Ineos has basically chosen to deliver market yields through OID not spread, with the euros landing at 400 bps and 96.5.

That’s exactly what the CLO market does not need. New money LBOs are thin on the ground, and may go to private credit; better credits like Ineos (or Stada, or Fedrigoni) can take steps to address their maturities but refi flow doesn’t really help.

Perhaps more plausible is the flow of collateral that may shake out of older CLO vehicles. With the refi and reset markets effectively closed, deals exiting reinvestment don’t have much room for manoeuvre…they’re entering a severe downcycle and a European recession. They can hold and hope, but may also lack the flexibility under the docs to deal with the complex restructurings and A&E issues coming down the track.

Hope isn’t much of a strategy — even if the market improves somewhat the old portfolios are still yielding 350ish — so that leaves liquidation. Call deals whenever there’s a loan rally; recover what you can and don’t mess around.

Five Arrows Credit Management (Rothschild) has been early out of the blocks in taking this approach, calling Contego II last week. The portfolio is out on BWIC, scheduled for Friday, which should give enough time for the usual leisurely loan settlement process by the time the bonds are redeemed on November 24.

Of course, the call incentives depend on the equity — and if equity starts changing hands, this could shake loose a few deals. CLO equity pricing is a mathematical question well beyond my pay grade, but a little rally in loans might bring more call options into the money; there’s a trade to be done buying discounted equity in secondary, calling deals and scooping up the spare cash.

Until recently there’d been relatively little equity up for sale, but some is now emerging. Gold says: “Despite the huge sell-off in IG, and subsequent high volumes lower down the stack, we've seen little trading in equity and dealers have seen light flows on and off BWICs in recent months. But we're now starting to see the emergence of the first signs of credit stresses in portfolios — at what point does that change views on equity and encourage positions to come out?”

Dip buyer in chief?

Once upon a time, Apollo’s press policy was simple, and could be expressed with a single digit of one hand. Things, however, seem to have thawed in the Marc Rowan era, and a kinder cuddlier Apollo is being cultivated. In CLOs, it seems to be trumpeting its role as chief dip-buyer, with pieces in Bloomberg, and another from the FT (lifted from the latest earnings call).

Presumably it was also Apollo that TwentyFour Asset Management’s Aza Teeuwen had in mind in this blog post discussing private equity shops buying CLO tranches…though as ever with the TwentyFour guys, the whole thing is worth a read, particularly the discussion of CMBS.

Some of the Apollo commentary doesn’t quite hang together though. The Bloomberg piece, published October 10, suggests Apollo could have made a quick five points on the supply coming out of the LDI funds.

At that time, most of the BWIC supply had been in seniors and double A. Generic senior spreads blew out to 260 bps or so on the first round of selling, then rallied a little but were still highly dislocated by mid October. Even if we assume Apollo bought the most beaten up blocks, how on earth do you get five points out of the price action between September 26 and October 10? Where’s the rally?

More recently, Apollo said in its earnings call, the basis for the FT piece, that “Over this three week period in October, our trading desk purchased $1.1bn of AAA and AA-rated CLO paper, yielding over 8%. We're confident that none of our competitors were able to move this swiftly or buy this significantly amid such volatility”.

That figure certainly puts Apollo among the largest accounts on the other side of the LDI unwind…though I am baffled by the 8% figure. Even if it bought all the triple As with a 3-handle discount margin (unlikely in that size), and even accounting for the basis back to dollars, it still sounds implausibly high.

Whether or not the numbers quite tie, it’s clearly good to be buying when others are forced sellers (most people involved in actively managed securitisation investing but not LDI have had a spring in their step over the last month) and I’m sure it will be a tidy trade for Apollo. But if it likes secondary seniors at 300, how does it feel about clean primary portfolios with better docs at 230? Will Apollo stick around or is this just a trade?

Also on the Apollo call was a little discussion of the Credit Suisse securitised products business, which it agreed to buy last week. Here’s CEO Marc Rowan in his own words…..

We believe that asset-backed origination has the potential to be as large a market as corporate credit. This is a product set that is primarily investment grade that fits extraordinarily well into our requirements for both our retirement services business and the third-party business we are building, would give us access to flow from more than 200 direct clients and accounts…..

…..something not fully appreciated is the changing role of banks, post Dodd-Frank. Many of the fixed income originating assets are the kinds of assets that in prior periods might have ended up on bank balance sheets. Securitization is now how America banks. We estimate that less than 20% of debt capital to U.S. businesses and consumers is provided directly by the banking system. The vast majority of capital is provided by all of you through intermediaries like us and our peers.

This does not mean we are replacing the banks. Quite frankly, we are now partners with the banks. If you think about what a bank wants, for the most part, a bank wants the client. They can sell the client payments and FX, hedging and M&A, and equity and a whole range of services that we and our peers are not really equipped nor do I believe we will be equipped to offer.

What we want is the asset. We want the asset on good terms, without fees taken out in advance, where we can have a direct look at credit quality and credit underwriting to control the documentation pen. Fixed income replacement, I believe, to be a vast market, where we are still in the early stages of its development.”

The crucial parts to me seem to be the last bit… “what we want is the asset”....and how this squares with the discussions we had last week — if Apollo and Pimco just want the origination flow, isn’t that value-destroying? Credit Suisse is very good at the distribution business, for now….will it still be good when Apollo and Pimco cherry-pick the best assets?

Sunscreen at Night

We were lucky enough to be invited along to KBRA’s European Solar ABS Event on Wednesday, and it was thoroughly excellent. “Rating agency afternoon seminar” may not scream “must attend”, but the crowd coming out was a signal of the excitement around the space.

KBRA don’t want client names discussed in the press but to give a flavour, we had one of the biggest sponsors in European securitisation there, representatives from several of the top alternative asset managers, senior folk from structured credit hedge funds and specialty finance shops, plus senior structuring and origination people from a broad range of top tier investment banks.

It emphatically was not a “send your juniors” type event — managing directors as far the eye could see. Even better was a strong attendance from many of the solar originators, in many cases traveling to be there….hopefully some good business got done over the beers after.

It was not entirely altruistic in spirit — KBRA is massively dominant in US solar ABS, and clearly wants to be the rating agency of choice when the market kicks off in Europe.

And it really does seem like it’s going to be soon. Private deals we know of include Enpal’s facility with Citi….apparently Enpal is originating €50m or so a month, so presumably it will be keen to extend or term out soon. There’s also the Barclays deal with Perfecta Energia, and presumably others in the works as well.

Other observations from the event — solar ABS fits in a sort of mid-ground between RMBS and ABS, from both a structural and a credit perspective.

Clearly the equipment is fitted to a home, so prepayment rates are connected somewhat to housing market activity (you can’t take it with you when you move), while credit performance is also more mortgage-like (partly because it tends to be prime-type borrowers who are homeowners).

Solar loans should be long-dated (to match the payback from the equipment), so deal structures will have to be more RMBS-like, with call options built in so the European securitisation market’s preferred 1-5 year tenors can accommodate the product. The products are likely to have longer fixed rate periods than most European mortgages, opening the way to structuring long tenor insurance-friendly tranches alongside classic short-dated floating ABS. Unlike a classic ABS, there’s not necessarily a ton of excess spread in the deals, so techniques like “Yield Supplement Overcollateralisation” (essentially harvesting a bit of principal to juice interest) might be required in term deals.

There’s formidable complexity built in, though, in the form of different state subsidies, lien structures and tax treatments, and whether this encourages loan products or leases. Some countries, such as Italy, subsidise citizens to own solar outright; in others, solar subscription or lease structures have more appeal.

But this is exactly the kind of thing securitisation people are good at — complexity means there’s an edge to be had. We’ve been big advocates for the development of this market (a potential €150bn asset class)…it’s a huge way that securitisation can help the world’s energy transition, and deliver some tangible “ESG” benefit that cuts through all the greenwashing nonsense.

Winning the treasury competition

Right now the smart play for securitised products is to show up to the market with plenty of precommitted financing in place, preferably in large-sized loan note format.

Bank treasury buyers are the main game in town for senior tranches, following the LDI unwind — even if a firmer tone is emerging in some pockets, the market’s a long way from being fixed. So we see chunky loan notes in CLOs from Barings and Oaktree, and £323m loan note at the top of Paratus’s BTL RMBS Twin Bridges 2022-3, priced this week.

Clydesdale's Lanark 2022-2, as we saw last week, actually had a lower portion of bank treasuries in the book than the last outing for the shelf….but still, it’s likely that a lot of the 1.3x demand in place at launch was bank treasury money. The loan note approach has been popular since June, with only brief interludes of public syndication, such as early September, but it’s more essential than ever now.

For the banks involved in the securitised products business, this changes the landscape — it’s a competitive edge to be able to show up and deliver 100m+ from your own treasury arm to take down bonds.

This can be a little like a game of pass-the-parcel between different arms of an institution….how much does it change economic reality to take a senior warehouse loan position held by the investment bank and convert it into a….senior loan position held by treasury? It’s a “deal” technically, and can help get some mezz placement out there, but as far as the senior risk is concerned it’s more of a round trip to a different floor of the bank and a different risk book.

Back in the day, JP Morgan was most adept at working this edge that its treasury bid brought, appearing on most of the flow deals in 2009/10/11, floating on the back of yards and yards of commitments to RMBS from JP Morgan CIO. Our impression (memories may have failed over the past decade) is that this disappeared around 2012, as the CIO came under scrutiny over the “London whale” affair, and the first of many Bank of England pushing-on-a-string subsidy schemes sunk the prime RMBS market.

JPM CIO has been in and around the market selectively at various points since, but does not seem to have insisted on lead roles for the JP Morgan investment bank in the deals it plays.

These days, the banks which seem best at the treasury/IB synergy in consumer products are CitiBNP Paribas, and possibly Standard Chartered (the latter something of a special case).

This makes it harder to disentangle how much the treasury bid is helping in the league tables, since these two institutions are more or less the top flow houses in Europe in good or bad times. Other big shops like BofA aren’t so lucky — the BofA treasury plays in CLOs, but the scars from the $50bn or so of RMBS-related losses in the GFC run deep. This conservatism has also kept BofA out of the risk retention game, another business-winning lever in securitisation.

Standard Chartered treasury has been a massive buyer for ages in CLOs and consumer products, and has built out a securitisation investment bank partly on top of this demand….it’s not so much that the treasury is showing up now in the difficult times and bringing a certain edge, it’s more that the treasury was ground zero for the whole operation.

Levels these days, though, should be sufficient to tempt even the previously securitisation-phobic institutions to throw some cash into senior tranches — but it takes time to gain approvals, expertise, and evaluate a new asset class….so the treasury edge ought to remain for a while.

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