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After a long pause in CBO issuance, Shenkman Capital became the first manager to revive the market (courtesy of a unique fundraising strategy). The floodgates may have opened with Anchorage Capital poised to follow with its own CBO.

Shenkman priced the $415.8m Romark Credit Funding III on 26 July via GreensLedge (an experienced hand as an arranger of CBOs), it what was the first CBO to be brought to market since Anchorage Credit Funding 16 back on 13 July 2022.

Shenkman’s return to CBOs was supported by Shenkman CBO Opportunity Fund I, which the firm launched last year to primarily invest in Shenkman-managed CBO equity, and should give the firm enough firepower to ensure Romark Credit Funding III is not a one-off.

It’s certainly unlikely to be the lone CBO issued this year. Marketing materials seen by 9fin earlier this week reveals that Anchorage is marketing to triple-A investors as part of its return to CBOs. Anchorage Credit Funding 17 is aiming to price as soon as the end of this week, or early next week (commencing 16 September.) For further details see 9fin’s regular US CLO pipeline piece.

Managers might be choosing this moment to return to CBOs with a view to pending rate cuts.

"For anyone who takes the view that rates will tighten faster than the curve implies, you could understand why they would want to try to find a way to lever a portfolio of bonds today," said one CLO and CBO investor.

There are highly rated bonds that are marked down because of low coupons, which could be a great investment if rates come down as fast as they went up and the structure has the right call permission, the investor adds.

At the moment, betting on rate cuts seems to have paid off. 9fin’s weekly US CLO primary wrap on Monday 9 September detailed the possibility of an outsized (50bps) rates cut at the next Fed meeting on 17-18 September.

Shenkman’s decision to return to CBOs wasn’t just a pure rates-play however, explains Jordan Barrow, co-head of liquid credit at Shenkman.

The goal of Shenkman’s strategy is to use the defensive properties of short duration high yield bonds to put the CBO in a position to purchase higher quality high yield bonds at a discount during periods of volatility and dislocation, Barrow says.

“During the past 20 years, over 90% of high yield bonds have been taken out at least one year prior to maturity. The current discount on short duration high yield bonds allows the investor to potentially earn upwards of 50bps of additional yield, if the security is taken out 12 to 18 months earlier than anticipated,” Barrow adds.

Captive equity funds aren’t just for CLOs

Although CBOs are nothing new — there was a wave of CBOs issued between 2015 and 2022, plus a sizeable 1.0 contingent — Shenkman CBO Opportunity Fund I is unique. It takes the captive equity fund strategy recently relied upon by CLO managers and brings it to the CBO market.

Shenkman’s private equity-style drawdown fund had a $300-500m target size, according to a fund presentation seen by 9fin. That amount was expected to allow Shenkman to price around three CBOs, according to sources.

That fund closed in the middle of January this year. Although the final close on the fund level was $250m, it is understood Shenkman CBO Opportunity Fund I raised additional strategy capital in SMAs and other formats that equate to the original target amount.

Barrow says the firm is aiming to price additional deals in the next 12-18 months, but it will be market dependent.

It has a six-year term from final closing date with one-year extension options at the sole discretion of Shenkman (plus one subsequent one-year extension subject to consent by Shenkman and a majority of limited partners) and a 2.5-year investment period starting on either the date of the first investment, or the six-month anniversary of the final close, according to materials seen by 9fin.

Management fees for the fund amount to 0.5% of the notional value of the assets held by the CBOs and other assets held by the fund (without double counting). Carried interest is 15% of distributions after the hurdle rate has been reached, subject to a 100% catch-up. That hurdle rate is 7% IRR net of fees and expenses, the presentation states.

Call optionality is key for CBOs, particularly in the current environment, sources say, and Shenkman CBO Opportunity Fund I’s investors should benefit from the recent pricing.

Barrow says the equity is more attractive from a structural perspective given the CBO did not have a make-whole on the triple-As, given the current environment.

So, how do CBOs differ from CLOs, and how have CBOs performed?

Liabilities are fixed rate in CBOs versus floating rate liabilities in CLOs, and tranches offer fixed rate coupons with 18-year maturity vs around 12 years in CLOs.

CBOs don’t need warehouses, given they buy liquid short-duration bonds. They also have different structural leverage versus a regular way CLO. CBOs are only 3-4x levered versus roughly 10x in a CLO, and that lower leverage gives more flexibility in trading without bumping up against collateralisation tests.

Cash flow distributions are also slightly different. CLOs lock in an arbitrage rate at the beginning of the structure (excess gains are the difference between assets and liabilities), which gets paid out in distributions, but trading gains along the way stay locked in the deal and get paid out to equity at the end. With CBOs, distributions can occur every six months, paying out trading gains and excess interest up to that point.

CBOs can also buy short duration high yield bonds that carry lower interest rate risk than longer duration bonds and rotate into high-quality high yield when high yield markets trade off. The aim is to pick up incremental yield during this rotation and then rotate back to short duration high yield when markets recover.

The outstanding market for CBOs is significantly smaller than CLOs. 39 CBOs were issued in the period between 2015 and 2022 (compared to 192 in the 1.0 era), by 12 different managers.

Shenkman has a long history with CBO management, having launched its first CBO in 2006.

Shenkman’s two older CBOs are Romark Credit Funding I which closed in 2020 and Romark Credit Funding II which closed in 2021. RCF I had a cash-on-cash return of 49.2% while RCF II had a cash–on-cash return of 16.1%, the presentation said.

Anchorage Capital is by far the largest CBO manager by AUM, with 15 CBOs under management. Alongside the new issue Credit Funding 17, Anchorage is also currently marketing a partial refinancing of Anchorage Credit Funding 12.

Until recently, Anchorage had not called any of the CBOs in its credit funding series. That changed recently, when it redeemed Anchorage Credit Funding 16 on 22 July. The fact that the first deal to be called was also the most recently priced, being active for just under two years, highlights the utility of having call optionality on CBOs.

CBOs rarely invest entirely in HY bonds: as of the latest reports outstanding CBOs had 55.8% exposure to bonds on average.

Variety abounds — there is 63 point difference between the CBO with the most and the least exposure to bonds. The macro environment is also important. Before the Russian invasion of Ukraine the average bond exposure stood at 38.2%.

CLOs have increased exposure to high yield bonds themselves since the repeal of the Volcker rule allowed them to add bond buckets (still typically capped at 5%.) 9fin wrote back in June that US CLOs were increasing turning to bonds to counteract par burn.

The other way in which CBOs have greater flexibility is higher triple-C buckets. Exact limits vary but 17.5% is common, compared to 7.5% for regular US BSL CLOs.

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Shenkman at the vanguard of CBO revival amid rate expectations

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