Excess Spread — Surveying the wreckage, rare beasts, non-call

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Excess Spread — Surveying the wreckage, rare beasts, non-call

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

Did they jump or were they pushed?

Just as I’d filed last week’s editionCerberus announced that it would not be calling Towd Point — Auburn 13, a UK RMBS backed by buy-to-let loans from Capital Home Loans (owned by Cerberus). This was not entirely unexpected.

Despite the limited extension risk across the broad RMBS markets this year, this was one of the deals that looked particularly vulnerable to missing its First Optional Redemption Date (FORD). A straight eye-balling of the step-up margins tells the story — senior steps up to 135 bps, double-A to 180 bps, single-A to 225 bps. If we consider Hops Hill 2, priced just before the chaos enveloped the market and backed by better collateral, the levels were 144 bps, 225 bps and 285 bps respectively, so there was a straight economic argument that Cerberus would let the bonds run.

That was before the deluge of forced selling crashed the market — and crashed UK BTL and non-conform particularly hard. Generic levels in Deutsche’s latest research cite BTL senior spreads doubling from 150 bps to 300 bps over the week. If an economic non-call had been a marginal possibility all summer, it was clearly advantageous last week.

My own (wrong) view, recorded here, was that Cerberus would call the deal on the FORD because Capital Home Loans was once again a “front book” lender with two outstanding warehouses for new origination, and it would therefore following the “maintain good market relations” playbook of repeat players rather than a more cold-eyed financial investor look at the pure economics.

Davidson Kempner’s call of Hawksmoor also seemed a good omen — like Cerb, DK is a financial investor, but also like Cerb, it’s a repeat player in UK mortgages and isn’t in a position to burn counterparties.

Though I was wrong about Cerberus calling at the FORD, the note suggests I was right that it wanted to. The notice says “The Mortgage Portfolio Purchase Option Holders will continue to explore a refinancing and the redemption of the Notes post-FORD on a subsequent Interest Payment Date in due course”.

In other words, there was a refi coming, it just got blown up by last week’s disaster. Nobody really expected the scale and suddeness of last week’s price action — even if you could see the early September window would be short and some kind of bad stuff was on its way, it was more brutal than seemed possible in the balmy backdrop of, um, mid-September.

A quick peek at the UK company registry is also suggestive. An SPV named “Towd Point Mortgage Funding 2022 - Auburn 15” was incorporated on September 22….just a day before the “mini-Budget” unleashed hell. Ouch.

Cerb appears to be trying to position this as akin to TwentyFour Asset Management’s missed call on Oat Hill No. 1 in 2020 — which, it’s fair to say, hasn’t hurt the reputation of the sponsor (just look at the Hops Hill 2 books).

TwentyFour was careful to position the missed FORD as a response to external chaos (the pandemic, in this case), and to signal that it intended to catch up whenever markets could support a refi, which happened at the next IPD. Bondholders were extended, but only by three months, very forgivable.

But one wonders how patient investors would have been if the Covid dislocations had persisted for three years instead of three months? TwentyFour was fortunate in this respect, informing markets about the skipped FORD in May, when central banks had stepped in and a rally was already under way….”despite a general improvement since April, the Portfolio Manager and the Board believe that better opportunities are likely in the months ahead”, as they put it at the time.

Cerberus is not so lucky — last week might have been the most acute phase, but there’s not a clear line of sight to a sustained rally. It might well have the best of intentions, but the question for Cerberus, and for ABS markets more generally, is…..when does the market recover?

Surveying the wreckage

It’s pretty clear that the UK asset managers dumping bonds into the market last week didn’t want to sell; as we saw, some of the bonds were so recently acquired they hadn’t even settled, and it takes a lot of time and expertise to build up securitisation portfolios. Deutsche Bank’s BWIC tracker puts average weekly volumes in EUR ABS at €425m and CLOs at €210m — so re-acquiring the €4bn or so of bonds out for sale last week would definitely be a grind.

Will the LDI money come back at all? Presumably the asset allocation folks at the various LDI funds are keen to stay pretty liquid until there’s some form of stability in sight, and who knows when that happens?

The Conservative Party conference this week, with multiple U-turns, backbiting, and the breakdown of Cabinet collective responsibility does not suggest political calm is on its way, and besides, there’s the withdrawal of Bank of England support and a rates decision at the beginning of November to get through.

If the FT’s lead story on Thursday is any guide, some of the LDI funds are now launching firesales of more illiquid assets, processes that won’t return cash for months. Insight Investment, one of the biggest sellers of ABS over the last week, was running 15%+ cash in its liquid ABS going into this situation….which we thought, pre Truss, meant we might be due a bit of an autumn rally.

But if Insight was also running similar cash levels in its LDI mandates, and still had to dump all the bonds it did…..the drive to cash must be very very serious, and is likely to extend rather than snap back.

There’s also the question of how the funds get back in, if and when they do. It’s hard to imagine a more price-moving way to exit positions than a huge amount of BWICs hitting screens all at once, clearly with highly motivated sellers.

If the LDI money does comes back, one might expect a more sober and stealthy approach to market. It will manifest as books that are 3x done instead of 2x, or as BWICs with fewer DNTs than usual — a firm tailwind, but not a storm like last week. They had no choice on the offer side, but will try to move prices as little as possible on the bid.

Bank of America’s research desk chalks up the activities last week as something of a victory for the securitisation markets, noting “we understand that the overwhelming majority, if not all, of the BWIC items traded, suggesting available and sufficient demand from investors for SF paper to absorb the record volume of secondary activity and buffer market prices”.

True, up to a point, but you can turn it around — securitisation lobby groups have been industriously claiming for some years that senior RMBS is liquid (and therefore should benefit from favourable treatment, be purchased by bank treasuries, count as part of HQLA and so forth)……it turns out the market can be banged up pretty hard by £2bn or so of selling pressure, if it’s the wrong kind of selling pressure. Senior RMBS is pretty liquid if you want to do decent sized blocks on a good day, but not when there’s a broad rush for the exits. Mind you, that was true of actually liquid, nailed on HQLA markets too, like, say, Gilts. Doing ordinary market size in Gilts before the Bank of England stepped in wasn’t easy!

More illuminating than a philosophical discussion on the nature of liquidity is identifying the specific kind that ABS markets did manage to display — we saw very large price moves, but, to Bank of America’s point, there was activity on the other side.

Dealer desks did have significant balance sheet to deploy (at a price), many of the bonds on BWIC traded, bank treasuries still have a bid for cheap seniors, and we saw some opportunistic money stepping in…funds which would normally be active down the cap stack but were putting on risk in seniors and upper mezz, likely to be owned on a levered basis (also a signal that there’s still risk appetite among the dealers). Despite the relatively small number of active accounts in European ABS/RMBS, there’s enough variety of buyers for some kind of functioning to continue. Prices moved rapidly but there was two-way trading.

What happens now? The Street is probably sitting on a lot of inventory right now, so much depends on how quickly this has to be recycled, and whether there’s much of a bid to sell into. Dealers generally dislike being very long over year-end, and some institutions will have three month hold periods….so some of the risk will be coming back out this side of Christmas. On the investor side, political stability will help (but…may be unlikely), while funds will want to get through the withdrawal of Bank of England support, and the November 3 interest rate decision before they want to get back into the water.

Put that together, and it might be a tough Q4 — if there’s buying appetite at all, it will come at the back end of the year, traditionally months of stasis and illiquidity. Dealers will be pretty heavy and getting nervous into year end, and primary is presumably going to be on the quiet side.

Aside from my misfire on the Cerberus FORD, I also said last week that we were probably done for specialist lender trades for a while. I guess I’d rather be wrong and interesting than right and boring, so thanks to Citi for giving me another error to chalk up.

I refer, of course, to the announcement of Canada Square Funding 7 on Wednesday. The deal was announced with a preplaced £199m senior loan note, which is presumably a bank treasury…and plausibly Citi itself. But the mezz is out to market, and looking to place down to single B level. That is going to be….expensive!

The deal is a refinancing of Canada Square Funding 2019-1, backed entirely by Fleet Mortgages BTL collateral, and, despite the branding, we understand the Citi principal group is not driving the bus on this one — the equity of the previous deal has been sold on to an asset manager, and the deal has to come now to fund the call due this month. The asset manager in question may also have deep enough pockets to take down the mezz if needed.

The shelf has previous with difficult markets — Canada Square Square Funding 2020-1, which did come direct from Citi, priced on March 12 2020, right in the teeth of the Covid sell-off. At the time the shutters were coming down all around…shipping the risk and getting it gone was the safest approach, though with the benefit of hindsight, holding the position until the summer would have meant better execution.

M&G followed suit with the announcement of a Finance Ireland RMBS on Thursday. Euros is a lot less damaged than sterling, particularly at the high quality, regulation-friendly end, but the deal is still taking a somewhat careful approach to market — the senior notes (STS and LCR eligible, catnip for the bank treasury bid) are fully offered, with “call desk” listed down the stack. Presumably there are pockets close to home that can hold the mezz if the levels aren’t workable.

So much for calling quiet primary!

How broken is the CLO market this week?

We spoke to a manager this week who affirmed that it was “very” broken, at present….but who had also just opened up a warehouse for their next deal, so go figure — it seems unkillable whatever the circumstances. There are just too many institutions keen to keep the machine moving, even if it means essentially pushing water uphill.

Senior CLO spreads suffered heavily from last week’s forced selling — around 37% of line items last week were CLOs, mostly triple A and double A paper. On Monday Prytania Solutions put triple A 60 bps wider on the week, and double A 99 bps. A trader described the senior market as “wholly dislocated and incredibly cheap”.

The rest of the stack sold off in sympathy, though proportionally suffered somewhat less…single B generic spread was 180 bps wider, for example, a 13% widening, vs the 30% widening in triple A.

TwentyFour Asset Management’s Aza Teeuwen wrote an insightful blog on the action (always worth reading 24AM commentary). He reckons selling this week and last is more than the last three months combined.

“Last week was something of a price discovery process as some sellers seemed to have no choice but to sell in order to meet liquidity needs, meaning prices dropped quickly and almost all AAA and AA CLO bonds that were auctioned traded,” he writes. “For BBs and Bs it was a different story as a large number of bonds ‘didn’t meet reserves’, with these sellers perhaps more opportunistic or just looking for clearing levels.”

This is bad news for the deals in primary, though Morgan Stanley successfully wrestled Partners’ Group’s Penta 12 over the line. Levels were 220 / 450 / 550 / 750, with the class ‘E’ retained and the class ‘F’ delayed draw.

Secondary levels at the moment are all over the shop but the broad picture is clear — this is inside the market at the senior level (anchors likely agreed a pre-Kwasi price) and wide down the stack. Aza puts class ‘B’ pricing at 350-400 bps, class ‘C’ at 450-525 and class ‘D’ at 600-700; the Prytania Solutions guys went for 395/483/668 a couple of days before.

Class ‘F’ has been more or less off the table for a while, certainly for any manager with access to enough equity not to have to issue, but retaining double-B notes hasn’t been seen since the immediate aftermath of the Covid onset.

There are definitely more locked up seniors out there — CVC Credit’s new deal has a Japanese anchor in place, so should be placeable, and European bank treasuries have been active, often supporting their investment banks in working through their pipelines — but transactions out there looking for senior support for execution in October and November are likely off the table for a while.

On the asset side, loans sold off in sympathy with broader risk assets, and are around three points down generically, but that’s not enough to fix the arbitrage. In effect, we’re in the same dysfunctional position as before the pension fund sell-off but turned up to 11 — skinny arb, a market that’s only accessible to managers with plenty of equity and price-insensitive senior, no realistic chance of resets for old deals coming out of reinvestment, and a recession incoming in.

Loans were not in the immediate firing line for last week’s LDI-driven sell-off — trading loans is a poor way to raise cash for a margin call, because the settlement times are too long…but if the LDI funds are still pushing on to raise more cash, there’s a decent chance that some of these could put further pressure on pricing.

There’s also the small matter of new leveraged loan supply. There’s a fair overhang of underwritten deals to work through, but European leveraged loans (particularly of the newish, high coupon variety) has slowed to a dribble. Banks complain that there’s not enough of a bid to do much more than €750m in the euro market; CLO managers complain there aren’t enough (decent, high margin) loans to support their vehicles and ideal issuance plans.

Verisure’s HY bond at 9.25%, priced last week, is the kind of promising material which could support CLO senior liabilities at 250 bps, but it’s fixed rate, so can only fit a few small pockets. Besides, we understand allocations were something of a bunfight — there’s very little new money, it’s mostly a refi — and the CLOs have to fight regular bond funds and even special sits type money at this sort of level.

Tendam’s FRN might be more promising still, at 750 bps over Euribor and 93 OID — a CLO portfolio comprised of FRNs at this level would definitely work. But….it’s only €300m, and most fund managers have spent the last several years explaining that they don’t like retail and wouldn’t invest in retail.

Rare beast

We’ve been banging on about the lack of European mid-market CLO transactions for ages now, partly through conviction — it’s genuinely worthwhile improving SME access to capital — and partly because of a vague European inferiority complex about the much deeper and more developed US market.

Anyway, here’s a small gesture in that direction. One of the top US mid-market CLO managers, Golub Capital, has blessed the benighted souls of the Old Continent with a euro tranche in one of its latest trades, Golub Capital Short Duration 2022-1.

Admittedly, it is only a €70m senior piece of a deal with $706.5m of dollar notes, but it’s better than nothing?

The deal is a static transaction, which solves one of the major impediments to the development of a euro-denominated mid-market deals — euro mid-market loans don’t really trade. Active management is not really possible in Europe, so the closest approximation is the plethora of private leveraging transactions on direct lending portfolios, often bracketed with “fund finance” rather than CLOs.

The euro piece is intended to form a natural hedge for some euro-denominated assets in the identified portfolio, some of which are issued by LevFin borrowers active in dollars, and which also include some Nordic assets, we understand.

Lots of mid-market US CLOs have a non-US bucket — Golub 59, for example, has a 15% bucket but some have as much as 20%. But given the frequency with which non-US borrowers choose to borrow dollars, there’s probably a lot of flexibility to use this bucket without needing to dally with euro-denominated.

There’s also been a fair amount of European interest in purchasing US middle market CLO liabilities over the years — a tell-tale giveaway is the decision to make transactions dual-compliant with European and US risk retention rules, as in past Golub deals, as well as deals from Monroe Capital.

Right now, the cross-currency basis and market dislocation in Europe makes that a tough sell — not only is the 200 bps SOFR spread on the Golub deal well inside the market levels for European CLO triple A, as discussed above, but the cross-currency pushes this down to the low mid 100s effective spread once its brought back to euros.

If you can buy European broadly syndicated loan CLO seniors in the high 200s today……that’s tricky. Offering a euro tranche right out of the gate, at 200 bps over Euribor is a little more appealing, besides the currency-matching benefits.

Morgan Stanley was the structuring lead, joined by NatWest Markets as co-placement agent.

Sorting Solvency

One of the potential Brexit bright spots was the potential for the UK to reform Solvency II, putting in place a more flexible regime for UK-domiciled insurance companies, which would (so securitisation folk hoped) turn the taps back on for insurance investment into securitised products.

Solvency II was a pretty hellish piece of regulation, whose passage showed the European Union’s legislative process at its absolute worst — the effects on securitisation are just one part of a fairly comprehensive mess. It’s under review in the European Union at the moment, but both candidates for UK prime minister pledged to get rid of it in their leadership campaigns.

One might question whether Liz Truss had actually read a single clause of the legendarily complex insurance rules prior to making this pledge, but nevertheless, UK capital markets could look forward to a future without it (at some point).

The past week or so has not just incinerated investor capital, however, but political capital too — how likely is it that following an unpopular pledge to ditch the bonus cap, and the near death of the LDI funds, there’s going to be much momentum for a big fat piece of complex financial deregulation?

So sad trombone not just for the massive sell-off, but for the prospects of an easier regulatory life ahead.

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