Market Wrap

Excess Spread — Off to the races, Gorilla warfare, Towering achievement

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

Off to the races

Credit is having a storming start to the year so far, and the CLO market isn’t far behind, with HPS Investment Partners kicking things off with Aqueduct 7-2022. As the name implies, it’s a 2022 deal, and one with a 2021-vintage warehouse.

HPS wasn’t in market with a new issue at all last year, although it has incorporated another two Aqueduct deals with 2022-handles (8-2022 and 9-2022). We actually wrote about the Aqueduct 7 deal briefly last year, on the back of a notice that “a Reinvestment Period End Date occurred on 17 June 2022”.

Presumably this little hiccup was resolved to the satisfaction of both parties (Bank of America remained in the arranger seat), though we have some questions about the actual collateral that’s in the warehouse.

We’d heard the deal had previously boasted high purchase price par-ish collateral, consistent with establishing and filling a warehouse in autumn 2021. The new issue, though, apparently came with a far more contemporary 91-ish average purchase level and 80% ramped.

What happened, we wonder, to all the underwater collateral? Has it been parked elsewhere to allow this deal to move ahead? If it went through a full reboot in June, then filling a portfolio in the 80s and low 90s would have been readily achievable, but who’s eating the losses on the old loans?

Syndication went stormingly, with coverage levels in the 4x area on the B-1 notes and more than 3x on the class D and E….though down the stack the initial thoughts were well back of secondary levels, so price certainly played its part.

If you think that CLO spreads had bottomed last year, there’s significant upside to be had buying recent vintage or new issue sub-IG paper where there’s a decent chance that the call will be in the money. Equity investors in recent deals have had to rely more on par gains from buying at a discount than on excess spread flowing through the structure, so they’re incentivised to flush par in a reset as soon as it looks remotely viable.

There’s more pull-to-par upside in secondary paper, but it’s hard to see a path to market conditions where it makes sense to reset old transactions with a liability cost in the mid-200s.

Anyway, the HPS deal is not exactly emblematic of the likely shape of the market for 2023 (most of the old warehouse overhang was worked through last year), but the strong print and rallying secondary market is prompting managers to move ahead with issuance.

If sellside spidey sense can be trusted, there should be a fair few transactions launching soon — and, perhaps, another technical squeeze in store for the loan market. Too many rapidly ramping deals chasing a dwindling pool of liquid CLO-friendly loans is a recipe for a rally, meaning the smart play is to get in early if you want to print in this window.

It’s also something of a bet on a CLO market that’s caught a meaningful bid now, including at the all-important triple-A levels. Everything in credit has been rallying; as is customary, structured credit has been following in more sedate fashion. It’s unlikely to be a pool of new investors or Japanese whale splashing about, so much as existing accounts feeling better, new money allocation for the new year, stronger data in the background and better relative value. CLO triple-A has traded sideways for months; we’re due a little bit of movement.

At the moment things still look too tight to shake out single-B supply — HPS Investment Partners retained this tranche, though at fairly optimistic level — and we wonder how much the issuance overhang for the delayed draw tranches printed in the last six months will weigh on spreads. It’s a fairly thin investor base who typically also play CLO equity and warehouses, so it’s easy enough for them to spy better opportunities elsewhere.

A thawing market is also a benefit, surely, for the increasing queue for debut managers who’ve yet to actually print.

Sona Asset Management joined the pipeline of aspiring CLO shops this week, with former Rothschild / Five Arrows PM Jacob Walton heading over to launch the platform. In other CLO moves, we’re still curious about Steven Paget’s plans. He left PGIM to launch Angelo Gordon’s platform in 2018, and was certainly successful at putting it on the map — so would he want to do the same thing over again at a new shop? Or is there a big seat out there at one of the established firms?

Off the top of my head the list of other debuts includes AB CarVal, Signal Capital Partners, Canyon Capital Advisors, and M&G (all of whom seem to have incorporated promising-looking vehicles), with reportings or rumblings from Pimco, Fortress, Muzinich, and Pemberton. CQS was the sole sort-of debut since the Russian invasion, with Acer Tree fortunately slipping out before the tanks started rolling.

None of these institutions are neophytes in the business of sub-investment grade credit, though there’s a wide array of institutional DNA on display here, from PE to bonds to direct lending to distressed — so an equally wide array of pitchbook storytelling when these managers approach the market.

Manager style is always an interesting question in CLOs, but never more so than at the beginning of 2023. Macro views aren’t our strong suit, but there’s some amount of bad stuff coming down the tracks, that’s for sure, even if it isn’t really coming through in corporate earnings so far.

So is it best to lean to conservative managers who are positioned defensively in the low WARF space? They should have more room to tactically increase risk and go on the front foot unconstrained by the structural limits of triple-C buckets and already high WARFs…..but can they switch style in response to these conditions, having carefully curated a conservative reputation? Is it better to lean in to the managers with proven records in navigating troubled credit?

A further question might be over how to read managers with a conservative reputation or low risk metrics in CLO land…..but capabilities in spicier credit demonstrated through other strategies? One might look at AlbaCore, Angelo Gordon, both securely in the “Low WARF High WAS” quadrant (i.e. getting lots of spread without taking lots of risk, at least according to ratings).

These firms are happily wading into some of sketchiest situations in European credit (Takko, Matalan for example) through their credit opps / distressed businesses….how much of this DNA gets infused into the par loans team in the coming tough times?

Make do and amend

We’ve been expecting a torrent of amend & extend activity in 2023, and this week the trend kicked into high gear. Altice France is targeting more than $8bn-equivalent of euro and dollar maturities in 2025 and 2026 with a monster transaction announced Thursday, but we’ve also had iQera, PortAventura, Nord Anglia Education, SafetyKleen, and we hear rumblings that some of the biggest capital structures in European leveraged finance (apart from Altice!) are looking.

Market conditions are supportive, prices are decent for the right credit — and there’s also a race against time to be considered, as more and more CLOs exit their reinvestment periods. Maybe this rally has enough legs to get some resets away, fingers crossed, but the base case has to be that lots deals start amortising. According to figures we dug up for the CLO Outlook (courtesy of BNP Paribas’s research desk), around 36% of the European market will be out of reinvestment by year-end, up from around 26% at the moment (already a pretty fearsome wall).

Figuring out what this means for A&E transactions isn’t straightforward, because CLOs have diverse language around the technicalities of what they can agree to, and what happens to any cash proceeds that come in. A tender and new issue, an exchange into new instruments or an amendment of existing facilities (or notes) might be structured to be exactly economically equivalent…..but might have very different implications for a post-RP CLO vehicle.

So would a manager prefer to have cash back, if this is just going to be dumped straight into senior amortisation, deleveraging the structure? Probably not! But maybe there’s some wiggle room.

The offer for iQera (a bond, but an FRN with a ton of CLOs in it) kind of illustrates the point — the French debt purchasing group is offering an exchange and a tender / new issue together, and paying subscribers to the notes (at par) five points straight away. This seems…complicated? Why not just offer the notes at 95? But presumably it has a purpose, and might relate to the technicalities about what to do with the cash.

The fearsome complexities of CLO docs are a little beyond us, but we’re looking to do lots more work on it as the A&E trend ramps up.

Towering achievement

So Belmont Green’s difficulties appear to be receding, with the announcement of Tower Bridge Funding 2023-1, the first specialist lender transaction of the year, and one of the only specialist lender deals since the savagery of the LDI sell-off (Canada Square Funding 7, for M&G and backed by Fleet collateral, slipped through in early October).

As we wrote last year, Belmont Green signed a very unusual financing in November, apparently pledging all of its existing residuals, plus warehouse residuals, plus real estate to raise some £25m from Macquarie.

Belmont Green stayed tight-lipped at the time, but, as various informed persons pointed out at the time, this suggested an extremely motivated borrower — pledging away the residuals really is eating the seed corn of the securitisation-funded lender. Alternatively, it suggested that Belmont Green knew that help was just around the corner. Was there an equity injection coming? A sale process? We’d heard the firm had been shopped around…

Our current best theory goes something like this: Tower Bridge Funding 4 was coming up for call in December. It was indeed called, and some £254m of the old collateral will be included in Tower Bridge 2023-1.

But the mortgages haven’t switched direct from one SPV to the other, and, seen from November’s vantage point, there must have been considerable uncertainty about whether it was possible to print in January at all, never mind at attractive levels.

Put that together, and you need some kind of financing to cover the call (if you don’t do the call, it’s probably game over, given that every other specialist lender has been diligently honouring its calls at First Optional Redemption Date or FORD).

Now, if you were calling £250m of loans, you might expect a 90%ish advance rate if the pool is decent, meaning you’d need to find around £25m of equity to put in. Coincidentally, this is exactly the sum raised from Macquarie in November!

Macquarie has a decent balance sheet, and is very happy to put it to work if the returns are decent, so it may even have supported this bridging facility as well as the residual financing.

It’s certainly joined the banking group for Belmont Green, as illustrated by the latest deal — BofA Securities and Santander are in the arranger seat, as they were for Tower Bridge 2022-1, with Barclays joining as JLM, just as in 2022. Macquarie and NatWest Markets are also in as JLMs, NatWest being a longtime Belmont Green bank, and Macquarie having dug the firm out of a hole in November.

The strong market this January has probably made this process less painful for all concerned.

It might be the first specialist lender deal off the blocks, but it’s emerging against a strong credit backdrop and rally in risk assets.

The two UK RMBS prints so far this year, namely the Brass No. 11 remarketing and Coventry Building Society’s Economic Master Issuer 2023-1 have limited read-across, given that both trades were senior only and Belmont Green announced with the seniors already spoken for. But the results were still encouraging! Coventry was 3.3x done, a subscription level it’s hard to argue with, and both managed decent tightening during marketing. Brass went to 29 accounts, EMI to 23, but both saw strong real money participation (44% and 39%), suggesting the sterling RMBS asset managers are back in business.

Another fair question about Tower Bridge 2023-1 is, who’s showing up for the senior? We’re hearing plenty about the UK bank treasuries buying in size, and there are three UK clearers on the mandate.

But it’s worth noting that this isn’t nailed on bank treasury type collateral — it’s mostly a buy-to-let pool, and the owner-occupied piece is pretty specialist stuff (non-standard properties, support schemes, complex incomes etc). That means no STS designation, and no beneficial liquidity treatment (the senior bonds cannot be “High Quality Liquid Assets” or HQLA).

Still, the securitised products arms of the JLMs have their own investment books — and as we’ve seen, these have been some of the biggest buyers out there over the past year.

It’s certainly a positive signal that Tower Bridge 2023-1 has come out with a public syndication for the mezz, and as of Thursday lunchtime, the decision looked to be paying off handsomely.

At the IPTs of mid-high 200s/mid-high 300s/mid-high 400s for class B/C/D (the relative vagueness underlining the fact that there hasn’t been public mezz for a while), books were 4.8x/5.3x/3x at Thursday lunchtime. Mezz subscription levels can soar pretty quickly because the tranches are small (£15.75m/£14m/£14m) but it certainly looks like we’re cooking with gasoline.

Speaking of calls and UK mortgages, it looks like Cerberus has been up to its old tricks, with notices from Towd Point Mortgage Funding 2020-Auburn 14 and Towd Point Mortgage Funding 2018-Auburn 12 announcing these deals won’t be called at FORD in February. Given that Cerberus has already missed calls on Auburn 13 and Vantage 2, it’s questionable whether this worsens its name in the market further. To take a hoary old cliché, you might as well be hung for a sheep as for a lamb.

On the other hand, the special pleading is becoming less plausible. The notices say “given current market conditions” the deals won’t be refi’d but, what’s so terrible about current market conditions? Current market conditions are >5x done on UK RMBS mezz?

Low WAC legacy collateral as in the Cerberus deals takes a bit more structuring to get a workable deal done, and that comes out of the sponsors’ pockets, but there’s a definite tailwind blowing through markets. Skipping a call after the trauma of the LDI selloff is one thing; skipping a call against a handily rallying market looks a little more like taking advantage.

Gorilla Warfare

Almost a year ago we flagged a brewing conflict over Silverback Finance, a 2015-era credit-linked CMBS.

The deal was fundamentally a sale & leaseback, but Santander, whose retail branches back the transaction, has been working on unwinding the transaction. It bought Uro Properties, the owner of the branches, in 2020, a move which triggered the loss of the crucial tax-efficient SOCIMI status (similar to being a REIT).

This in turn triggered a “SOCIMI Status Loss Event”, requiring mandatory prepayment of the loan and an early redemption of the bonds….but the question prompting the fight is….does this prepayment come at make-whole or not?

The fight was rumbling on all of last year, with BNP Paribas Trust Corporation (the CMBS trustee) lined up against Uro Property Holdings. Late last year, Mr Justice Jacobs provided a judgement, which I’m taking a look at here. It’s in response to Uro’s application for summary judgement and striking out the claim….which the good judge declined to do, clearing the way for the case to go to trial this year.

Big picture, the crucial point is whether Uro lost its crucial tax status “by any act or omission of Uro” — if it’s Santander/Uro fault, then pay make-whole, if it’s not (e.g. a change in the tax code) then don’t.

However, the litigation so far, including the attempt to strike out the claim, is focused on the in-depth mechanics of the make-whole, including how it should be calculated, whether it can be calculated retrospectively, and what procedures had to be followed.

BNP Paribas and the bondholders appointed Rothschild as financial adviser in August last year, with Rothschild contacting various Bund dealers to get a retrospective quote. But Uro argues that the calculation had to happen on February 7.

According to the strike-out judgement, there’s a decent amount of dough at stake — €251m to be precise, according to a calculation served in September 2022.

As per BNP Paribas’s argument: “If Uro's construction is correct, Uro would receive a windfall of €250 million at the expense of the Bondholders. The ultimate beneficiary of the windfall would be Santander (as the parent company of Uro), since Santander would effectively be able to block rental payments of over €250 million from being remitted to the Bondholders. Having acquired Uro's share capital (thereby destroying the tax advantages of the securitisation structure), Santander would then be able to prevent the Bondholders from receiving a very large proportion of the returns to which they would otherwise be entitled – solely by reason of a delay in obtaining quotations of Bund prices.”

The case against is broadly summarised by this argument, from Uro…tldr, the contract says the calculation has to be immediate (it turns on whether the calculation can be made “on” or “as at” the relevant date). If it didn’t have to be an immediate calculation, surely it would say so in the bond docs?

“[BNPP’s] case would involve the court re-writing the very contracts it seeks to enforce via a process of construction or by implying terms which contradict the express contractual mechanism agreed. Essentially, BNPP's case is that the mechanism and dates for calculating and certifying this alleged liability are matters for the Issuer's discretion, and the agreed contractual mechanism (requiring live quotations obtained at the specified date and time) should be replaced with one permitting the Issuer to use estimated prices obtained long after the event at a time and date of its own choosing. In the alternative, it suggests the court should ignore the contractual mechanism altogether and perform its own ad-hoc determination of the [make-whole].”

The court seems pretty sympathetic to BNPP and the bondholders, on the basis of this judgement, though we’ll see where it ends up — there was a hearing last week. We’ve been a bit too jammed to wander down to the courtroom thanks to the glorious market opening that’s been occurring, but we’ll monitor it with considerable interest.

Mr Justice Jacobs said: “The….argument produces the uncommercial result that BNPP's entitlement to the BMWP was dependent upon the complicated process working sufficiently smoothly so as to produce quotations on the Reference Date itself – in circumstances where there were risks that this would not happen, and where such risks were not identified in the Prospectus. Uro's contrary argument results in the [make-whole] becoming a very fragile contractual entitlement, despite its importance (on Mr Mark's evidence) to the pricing of the Bonds and its obvious commercial importance.”

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