CLOs

In the past few weeks CLOs have become the focus of much attention, both from market participants and the media, especially following the negative rating actions that agencies have taken on the underlying loans as well as CLO tranches.

After six weeks of no supply, the market somewhat surprisingly reopened with three new issue CLOs being priced last week and a new one already on the way. We are aware of many loan warehouses that need to be cleared, and bankers (or rather their risk managers) are no doubt keen for CLO managers to refinance leveraged loans into a CLO.

In the last two weeks we’ve looked at how CLOs behaved during the global financial crisis, and we’ve stress tested a current CLO with GFC-like defaults to see where individual tranches would start to take a loss in that scenario. Keeping in mind the rule that the third in any trilogy is usually either the best or the worst, let’s hope this third instalment is more Toy Story 3 than Tokyo Drift.

Clearly this shock/stress test is a severe scenario, but given the uncertainties that COVID-19 has thrown our way, as debt investors we would rather be overly conservative.

In recent weeks we’ve seen significant sell-offs across all asset classes as investors have been scrambling for liquidity. With most of Europe and the US effectively in lockdown, a recession looks to be inevitable and the question is what this will do to corporates’ ability to service and refinance their outstanding debt, especially for those in the sub-investment grade space.

Given the material positive performance seen in other parts of the fixed income markets in 2019, the CLO relative value proposition now looks even more attractive.

We have already highlighted the blistering pace of bond sales in both Europe and the US, and this being met with apparently insatiable demand from fixed income investors. Since European ABS markets tend to lag broader fixed income, it seems fitting that we have had to wait another week before seeing that primary machine start to accelerate.

Rates risk is not something we concern ourselves with too much in the European ABS market, so normally news of inverted yield curves and 30-year US Treasury yields dropping below 2% would largely wash over us. This is because pretty much all ABS bonds are floating rate, so there is no duration. Or is there?

On Monday my colleagues on TwentyFour’s Multi-Sector Bond desk published a blog on rising default risks in high yield credit. Dummen Orange, Douglas, Boparan, Moby, Galapagos and CMC Ravenna are some of the obvious under-pressure names held in loan funds and CLO portfolios that are trading at a significant discount in the market.

It’s been an interesting week for European CLOs; one of our favourite picks in fixed income. 

Five years ago, the European CLO market restarted when Cairn issued the first post-crisis CLO in Europe – the start of the 2.0 market – and after a slow first year we have seen plenty more CLOs coming to market from a large mix of legacy and new managers.

As most of our readers know, ABS is an asset class that lends itself well to detailed underwriting, from onsite due diligence through to cashflow and risk modelling.