Market Wrap

Excess Spread — New CLO powers, floors and freakouts, Riz on the run

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

Acosta lot

There’s been some amount of griping in the distressed debt community since late 2020, when the vaccines kicked in, and it became clear that the massive dislocation funds raised in the wake of the pandemic were going to become hard to deploy. See a recent example from Bloomberg.

But we wonder how much of it is down to the actions of the funds themselves — specifically in the Acosta restructuring negotiations, right before the pandemic struck. This saw a distressed debt rogues’ gallery, including Elliott and Oaktreeburn a bunch of CLO managers, who found themselves unable to participate in the new money, and therefore take any upside from working out the company.

It paved the way for the introduction of loss mitigation language in CLO docs, which was given an extra push when the pandemic hit (along with expectation of another restructuring cycle in leveraged loans).

That cycle hasn’t really happened yet, but we wonder how different it will look now CLO managers are tooled up and ready to play in more complex workout situations. The loss mitigation language hasn’t been used or tested at all in European loans, but it’s continued to move on.

At first, only interest proceeds could go into distressed “new money” facilities, but that evolved to include excess principal, and then to principal proceeds which count towards the CLO’s par tests. 

Other steps to loosen things up include flexibility on maturities, allowing CLOs to play in assets which might have maturities beyond the legal final of the CLO vehicle, or to invest in loss mitigation loans without messing up their own weighted average life tests. The controversial points up for debate at the moment include how exactly the CLO should book its loss mitigation obligations, and when any sale proceeds can be flushed out to equity.

“Since Covid kicked off, CLOs have been thinking through how best to deal with restructurings, but like everything else these haven’t stood still since 2020 — there have been continuous negotiations with investors on how to buy loss mitigation obligations, with what money, and under what conditions,” said James Smallwood of A&O’s CLO team. “One of the key discussion points at the moment is the flexibility to purchase LMOs (or indeed agree to portfolio asset restructurings in general) with maturity dates beyond that of the CLO, and the effect on the WAL test of the deal.”

That means, at the margin, CLOs are going to be less willing to sell to avoid a restructuring, and more likely to look for routes to drive the process themselves. That should make it harder for distressed funds to source investments in attractive size and at attractive levels, while potentially skewing the next round of restructurings to more debt-friendly outcomes — the incentives of par investors are very different to distressed funds who bought on the cheap.

It might be time for that pendulum to swing back. The last round of restructurings, especially of US companies during 2020, resulted in haircuts that were too aggressive to the debt structure, and left CLOs sitting on historically high levels of “reorg equity”.

Pearl Diver Capital, which plays in equity and low in the debt capital structure, is calling for managers to get on and monetise these positions. It says the value of “reorg equity” in CLOs (shares resulting from restructurings) has increased by 20% over 2021, with around 50% of this value in 2016-2018 vintages. 

Much of this, especially in US deals, comes from 2020-era restructurings, in which distressed investors successfully cut the debt load of companies — arguably more than was necessary, given subsequent economic conditions.

But still, some of these positions — Pearl Diver points to Cirque Du Soleil — have risen quite sharply, with Cirque up 3x over the year.

But as the firm notes, for every Cirque, there’s going to be another company where the equity value halves. Not all companies end up back on their feet following a restructuring; many are serial restructurers whose business model never seems to work properly, and hanging about waiting for the next accident isn’t the kind of business CLOs should be in.

It’s a short note, and very much to the point. Pearl Diver concludes: “The mixture of interest rate rises, persisting inflation and supply chain issues, combined with geopolitical risks all point to a more volatile period ahead. We think that given the value appreciation, now is a good time to exit reorg equity and realise the value for CLOs.”

That’s not necessarily easy — unlisted equity stakes in formerly troubled businesses aren’t the most liquid assets out there, and the best bid might well be the distressed investors that drove the original loan-to-own restructurings. But if it takes time, all the more reason to start early, rather than dumping it when the deals are called.

As with anything in CLOs, manager matters. An increasing proportion of CLO managers now sit within broader credit investment platforms, which often have their own in-house special sits and restructuring teams — and, in theory, the skills and appetite to be in the driving seat, rather than trade out at the first signs of trouble.

But it’s not as simple as saying that any manager with a distressed business is in a good spot to handle workout situations. Even if they’re under the same roof, the teams might not talk to each other, for reasons of culture, geography, incentives or even regulation. A busy distressed debt desk is likely to be more focused on the upside from a position it bought at 50 rather than helping their par loan brethren firefight on a position they bought at 99.

Freakouts and floor value

It’s been a wild week in broader markets, and there’s a definite softness creeping into parts of credit…but there’s some nuance to it. Much of the action in European credit came following the ECB meeting last Thursday, which led to a rapid repricing in rates curves, and some commensurate punishment in fixed rate bonds. 

CLOs, though, are a weird animal, thanks to the behaviour of the Euribor floor - floating rate notes which have been effectively fixed rate since Euribor turned negative, but with embedded rates options that aren’t always properly valued.

The rapid steepening of the euro rates curve makes the floor less valuable (if Euribor is likely to be positive during the life of the deal, the floor doesn’t operate), but options are more valuable when volatility is higher, which it certainly has been in euro rates.

We’ve heard of CLO trading desks, and even rates traders stripping out and monetising the floor, but euro-based asset managers may simply take the spread uplift and worry about it no more. 

It matters very much for investors buying against a currency swap, since hedging through the cross-currency basis can crystallize the benefit - and big offshore anchor accounts have indeed moved into the market in size during periods when the floor was especially valuable.

More generally, as the folks at Bank of America research explored in a recent note (ask them for it, it's a good one), the effects are pretty different for bank and non-bank investors, because bank investors can be assumed to fund their positions on a Euribor basis. Once Euribor turns positive, returns to asset managers keep going up, but banks’ funding costs go up at the same rate as the CLO interest payments.

bank funding costs go up at same rate as CLO

Of course… don’t seem to care about all of this theory. A steeper rates curve, reductions in the floor value, and discouragement of bank investors should all point to weaker demand for senior paper, and have little effect at the bottom of the stack.

Anecdotally, however, it’s the other way around, with senior investors hungry for action and taking new deals and resets tighter again, while down the stack appetite is a bit lighter, and spreads are softening.

Sculptor Capital’s new issue, Sculptor European CLO IX via BNP Paribas, landed at 962 bps on the single-B on Monday — another leg wider and managers will probably start to cut this tranche entirely. Indeed, it’s started happening already, with the reset of Dryden 39 2015, priced on Wednesday via Morgan Stanley, listing the single-B tranche as “not offered”.

This might be a more bespoke situation — it’s an old deal with a few hairy credits, and PGIM’s trademark bond-heavy approach has been smacked by the rates moves — but new issues might start to question the value of issuing single-B as DMs head towards 1000 bps.

Euribor floors or not, if there’s going to be a prolonged bout of credit market vol it’s probably more relaxing being senior than riding the waves in the sub-IG tranches.

Investors down the stack are also more likely to be opportunistic across credit products, and dislocated high yield bonds have suddenly got a lot more attractive, rates vol notwithstanding. Reaching for yield no longer necessarily means buying terrible companies - there are bargains to be had once again.

This might make the market more vulnerable to supply technicals. CLO supply has been relatively modest this year, at least by the comparison to the waves of issuance with new issues only just emerging.

But big picture, the backdrop looks good for more CLO formation, even if syndication is a little stickier at the moment.

Loans are still pricing, but at levels healthily above 400 bps, rather than squeezed down to 375 bps or 350 bps. Investors are successfully pushing back on the usual array of economic terms (in Hunter Douglas, for example). Even better, for existing managers and equity, the risk of repricing has receded, with few loans trading at the par plus levels that might support a margin cut. That points to fat and stable arbitrage going forward — if the CLO debt market can digest the supply.

Riz on the run

Covering Rizwan Hussain’s activities has been quite an education in the English legal system. Following last week’s arrest warrant, he’s still missing, though the “Tipstaff” is on the hunt.

For those that don’t know (me until three days ago), a Tipstaff is an official title dating from the 14th century, with a wide array of powers to compel citizens and officials to do things (such as find Rizwan). There are only two, one an officer of the Royal Borough of Kingston, and the other an officer of the High Court of England and Wales. The Tipstaff leads a procession of judges at the start of the legal year, and lead the Lord Mayor of London for their swearing-in ceremony, and they are the only persons who can make an arrest within the Royal Courts of Justice.

Whoever this Tipstaff may be, they sound like a total badass, but they haven’t found Rizwan yet. But his absence hasn’t stopped proceedings. The judge in his committal hearing decided to go ahead and hear the application anyway this week, having briefly adjourned last week. Unfortunately the big finish is set for Friday, after Excess Spread will go out, so it’s a bit of a cliff-hanger, and there’s a lot of heavy-duty legal procedural stuff.

That’s not surprising — the Rizwan MO has been very much about putting up absurd legal procedural obstacles and issues. Like an octopus, when under threat, he emits a cloud of ink to cover his tracks. So it’s a testament to the dedication and determination of the Simmons & Simmons team and their barristers, acting for Sanne Group, that they’ve made it this far.

We can’t help thinking that, even before it all started falling apart for Rizwan, that he’d have done a lot better just….being a securitisation banker. 

He seems to be smart, with a considerable slug of structuring expertise and, as has become evident, a deep and creative interest in the legal underpinnings of securitised products. It’s not a badly compensated industry, and he had lots of experience. By this point, if he hadn’t gone off the rails, he could well have been running a midsized specialist lender, or the mortgage group at a decent bank.

Watch this space for more!

Thanks ECB?

In consumer ABS and RMBS it’s been a fairly quiet week, with two new announcements — TwentyFour Asset Management’s Barley Hill No. 2, securitising a £288m pool of owner-occupied mortgages originated by TML. It’s a specialist lending pool, with a big slug of self-employed borrowers in there, who took a high proportion of payment holidays during the Covid period.

It’s also the first time TwentyFour’s UK Mortgages vehicle has opted to keep its regulatory risk retention in vertical slice format, rather than horizontal — which gives it the option of easily selling equity down the road if the price is right. In the new issue, though, it’s still retaining the bottom of the capital structure, as it usually does, but has more optionality down the road.

Market conditions might not seem stormingly good right now, but it’s a clean UK RMBS kicking off tons of spread, and in a market without much supply — let’s see what next week’s levels bring us when it moves forwards from marketing to execution.

Priced this week was Finnish auto ABS “LT Autorahoitus II” (me neither), more popularly known as Tommi 2, after legendary Finnish rally driver Tommi Mäkinen. It wasn’t an early January-style blowout, with both tranches 1.3x done, and the €568.5m class A landing at 21 bps. By any reasonable measure that’s a good level for a specialist finance company to fund at, still deep in negative territory — though core German autos were threatening single digit territory not so long ago.

The deal did serve as a reminder that, for euro-denominated assets in tougher markets, there’s still a strong central bank bid out there keeping markets open — central banks/official institutions took down 40.7% of the deal. 

That might have explained the high allocation to “France” in the geographical breakdown (57.5%), with only six of the Eurosystem’s central banks actually active in making the purchases. National central banks in Belgium, Germany, Spain, Italy and the Netherlands buy ABS from their own countries, while the Banque de France covers France, Ireland, Luxembourg, Portugal, and, crucially for Tommi, Finland.

We also saw the Harben and Ripon refis taken off the table this week and late last week, as we predicted — £7.5bn of UK buy-to-let mortgages privately placed, and no longer hanging over the market, ahead of the call dates for the original 2017 deals later this month.

We did think there might have been more of a public offer in the smaller Harben deal, especially in the mezz, but with markets this ugly it looks like leads Barclays, Lloyds and NatWest went for pre-placement. That doesn’t necessarily mean a distribution much narrower than that in a regular UK RMBS — 10 accounts will probably cover off most of the buyer base by volume. 

Elstree No. 2, a fully public deal, went to 12 investors, though the inclusion of 2nd lien in the portfolio will have put off a couple of accounts.

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