What is Happening in the CLO Space: Investors’ Ideas.

“Look carefully, because what you'll see is not what you just saw”: Leonardo da Vinci.

In the first week of June investors, issuers, portfolio managers, structuring banks, lawyers, will gather in Barcelona for the ABS conference. ABS people are definitely motivated and in good spirits given the significant tailwinds supporting the credit market and a general optimism towards structured products. A completely different scenario from 2022 when I signaled, at that time, in a note before the conference, how big black clouds were in the sky on top of the Catalan city. During 2022 AAA CLO paper passed from 100 bps spread on Euribor to 200 bps by the end of the year, AAs from 165 to 400, BBBs from 325bps to 650 bps. Bs notes were in many cases, not issued. Barcelona, two years ago, was just in the middle of a widening credit trend started in March 2022 (and finished only 12 months later).

If the conference at that time “did not accelerate” structured finance products (to use a definition that organizers like a lot), this year is very different: the tone is constructive with tight spreads across sectors even if the primary supply has remained very busy. CMBS started to appear in the market, consumer ABS transactions are several times oversubscribed, and CLOs are in good shape with decent volumes, new deals, resets and liquidations (very normal with ELLI, the loan index, today above 98, same level of beginning 2022, before it dropped to 89 in Q4 2022). European CLO are also in good health.

There is a broad based momentum supporting the market despite the uncertainties around interest rates, economic growth, idiosyncratic corporate events, and significant geopolitical risks.

So, regarding CLOs, where should the investors pay particular attention? I need to write my ideas in short points, as every topic deserves actually many pages of analysis and I will refrain from giving the solution keys to all my doubts and to provide details on specific characteristics of CLO deals and portfolio managers’ underlying pools.

That said, here they are. The ultimate aim is understanding the risk and getting its correct remuneration.

1. Repricing deals in the loan market are on track to reach the record levels of H1 2017. Probably the movement, today, is more pronounced than 7 years ago. Everything with 6 months plus 1 day since issuance day, is repricing: better rated issues but also Bs loans. What is the effect on WAS compression and on the cushion tests? A squeeze on CLO portfolio spreads has the obvious impact on excess spread and consequently equity distributions. The analysis on the repricing wave of 2017 and the Q4 2017/2018 equity coupons is available for people who want to study it and to understand if the WAS (weighted average spread) and WAC (weighted average coupon) are what they are shown in the excel spreadsheets, and, most of all, where they will go and stop. Are the dummy assets credible (and I add “consistent” with what is going on) with vehicles not ramped even at 50%? More: we know that equity distributions are only one way of measuring equity performance as other metrics like “par build” are also important for assessing value for the equity piece: with many loans trading near 100, how is possible today to create par? How is the repricing wave affecting the underlying pools with 2 years no-call, 1 year no-call, out of the reinvestment period? Deals age and the impact is not homogenous because tests are imposing different and bigger restrictions on old securitizations.
2. If loan repricing activity continues at the current pace and CLO WAS remains under pressure, it is sure that CLO managers may look at refinancing or resetting CLO debt for getting a margin benefit to offset portfolio WAS reduction. CLOs out of non-call are the obvious candidates, but what about what is out of reinvestment period?
3. European CLO platforms are growing in numbers, but they are increasingly (and alarmingly) replicating each other. Collateral overlap statistics (the metric provides a high-level understanding of the single-name risks associated with the overlaps between the loan portfolios of different CLOs) show that the percentage in Europe passed in less than 10 years from 25-30% to 45%. Some CLOs in specific quarters price with 50% overlap when compared with the rest of the market. These numbers provide a good bird's eye view of one aspect of a manager's credit selection. From liabilities investor’ perspective (for equity this is obvious) are those metrics useful to improve the understanding of their beta exposure, especially further down the capital stack? How an overlap study across ”new and seasoned vintages” can help investors in discovering the tail risk in the portfolios and in identifying excessive unwanted risk or opportunities where some portfolios do share the same metrics and collateral but the liabilities quote at different prices? Is it worth buying the same manager when the overlap reaches 80% across deals managed by the same platform? ( ten years ago this percentage was 63-65%) Deal diversification always means risk diversification? How does this correlation change in time?
4. Are stressed/distressed assets among deals diversified? The generic rule should be a higher degree of overlap among better quality-lower spread-loans across CLO portfolios and not much overlap among the lower quality-higher spread-credit names, suggesting that from a tail risk perspective, CLO portfolios are diversified. Are we obliged to review our investment approach and this rule when a case like Altice-held by 90% of managers-happens in the market? And what about correlations at industry level (debt collectors or pharma for mentioning two examples) and across sectors?
5. In a world where the collateral is scarce, are CLO managers mostly buying the market (buying beta), or are the PMs credit selectors who construct different portfolios from each other? What are the alpha and the beta components in a given portfolio? In other words: how is the tail-risk distributed among deals? Many styles of portfolio management look, in my opinion, more frequently the same (by necessity?).
6. How the bond bucket and its utilization are affecting the European CLO tests: WARF, WAS, and the quality and depth of MVOC and NAV levels? Do the portfolios have more price volatility? And interest rate risk? (the AA fixed component is not used in some capital stacks in the 2024 vintage). Today the average bond bucket percentage used in the underlying assets is 15-16%; some years ago this number was 5% (I remember some managers, that I will not name, refused categorically to use bonds in the portfolios. Today they do. Personally, I always had the second largest bond bucket in the industry, so I believe in the asset class). Some European managers use between 20% and 25% of bonds in the vehicles skewed (voluntarily or unintentionally) to a similar set of issuers as the leveraged loans: same rating cohorts of single B/B-. The questions here are the following: which are the bonds that are used? SSNs over the SUNs ? When the unsecured part of the bond exposure is trading at 85 or 80 cents, does it deserve to be included in a CLO portfolio? (Altice case is the perfect example, as CLOs bought also unsecured exposure) In which way does the shrinking of the investable HY universe priced around or above 100 in the market, stimulate the creativity and alter the investment style of portfolio management of the various PMs?
7. How are the technicals in the European bond market being affected by the CLO demand and the needs of ramping up and setting up managed or static vehicles? In other words: do the bonds prices of certain issuers still reflect the fundamentals and the credit qualities or are they swayed by the CLO demand? This is relevant, again, for the tail risk and the companies’ probabilities to pay the interests and to repay their debt in the balance sheets.
8. The CCC bucket: when does it start to bite the performance and the ability of the PMs to trade the portfolio? The sterile and poor conversations on Altice name made me understand the little knowledge of some people. There are other risks looming in the CLO portfolios.

Everything I wrote above is extremely important for the investors in the European CLO market. Equity investors have received a large coupon payment in April 2024 and they are still wondering how that has been possible. Another proof that some investors have a strange knowledge about how vehicles work, the risk embedded in the portfolios, and why the waterfall produces certain results or not. The questions above should be the talking points around any conversation about a given pool of asset to discover the best value proposition within the CLO capital structure. The CLOs are evolving and growing, and investors and portfolio managers still remember the famous tirade, now disappeared, on the covenant-lite deals. In light of the fact that the covenant-lite no-sense mantra stayed alive for 20 years or more, this means how some ideas die hard, while others, more useful, do not flourish and do not adapt to evolving market conditions and how the portfolios are currently managed. It is compelling, instead, to follow the structures’ evolutions and the points that at any given time really matter.

There will be an important and interesting manager tiering in Europe and in the US. I started this piece with Leonardo da Vinci, I finish this note with him again: “the details make the perfection, but the perfection is not just a detail”.

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