Bets on risky CLOs are paying off with 20% gains: Credit Weekly

(Bloomberg) — Returns on the riskiest part of collateralized loan obligations are rising, reaching about 20% annualized on both sides of the Atlantic, as loan performance improves, debt spreads narrow and payments increase.

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In some cases, a structural quirk that allowed managers to place new debt on old businesses also helped returns on the equity slice, the first piece of the structure that suffers losses. Money managers who create CLOs – bonds backed by a pool of leveraged loans – are taking advantage of falling financing costs and issuing more bonds with lower ratings rather than holding on to them.

Many are now selling what is known as a “class F deferred tranche,” adding it to an older CLO. The money they make from sales can reward shareholders with further distributions.

“Managers are able to transfer proceeds from the sale directly into equity, which can lead to bumper returns,” said James Baillie, structured credit partner at Paul Hastings in London.

Deferred tranches are another example of how issuers are taking advantage of a strong recovery in risky debt, as fears of a recession ease and prices recover after a prolonged, turbulent period. Since the start of the year, more than a dozen such agreements have been issued in Europe by CLO managers including Invesco and Capital Four.

Stock returns have also been helped by several CLOs that have exited their non-call period, meaning they can be refinanced, restarted or liquidated. The new prices and extended investment terms could also free up more money that can be sent to the equity tranche, Baillie added.

“In both approaches, you move from a less leveraged position to a more leveraged position and that gives you, in some cases, an equity dividend,” he said.

CLO stock returns have been unstable in recent years due to arbitrage fluctuation — or the difference between the yields a manager earns on the loans it buys and the financing costs of the bonds it issues. After falling in 2023, European arbitrage levels have stabilized this year at around 200 basis points, and have recently started to rise marginally, according to Bloomberg Intelligence.

“In 2022 and 2023, spreads were wider across both assets and liabilities, which made placing third-party CLO shares more challenging,” Ben Hunsaker, portfolio manager at Beach Point Capital Management, said of the securities market. USA. He said these businesses have likely had strong capital payments since then and should be able to refinance their liabilities when their non-call periods end.

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The problem is that these returns may not last. Investors in CLO stocks could see arbitrage fall again if global central banks start cutting interest rates this year. An increase in financial distress could also erode returns, although it has remained limited for now.

“The market was pricing in defaults of 3% to 4% last year and defaults of 4% to 6% this year, but we saw significantly fewer defaults in CLO portfolios, which benefited CLO equity,” said Dan Ko, Director senior and portfolio manager at Eagle Point Credit Management.

Click here for a podcast about Invesco’s purchase of REITs and bank bonds in the ‘Golden Age’ of credit

Week in review

• Credit optimists point to a set of metrics that show that high-quality bonds have rarely been this cheap, increasing the appeal of corporate debt at a time when it offers few advantages over government bonds.

• Investment banks including Goldman Sachs Group Inc. are proposing largely syndicated refinancings of some of the riskiest types of private credit, in the latest sign that Wall Street is trying to steal business from direct lenders.

• For the first time since the financial crisis, investors in highly rated bonds backed by commercial real estate debt are being hit by losses.

• Robo investors are increasingly taking control of credit markets. The shift is pitting investors with technical doctorates against traditional portfolio managers with management training.

• United Parcel Service Inc. sold $2.6 billion in high-quality bonds as companies rushed to price new debt ahead of the Memorial Day holiday. Coca-Cola Consolidated Inc. raised $1.2 billion in notes to repurchase shares and data center owner Equinix Inc. sold back $750 million after canceling a planned offering in March following an attack by short sellers.

• Alibaba Group Holding Ltd. sold $4.5 billion in convertible bonds, a record dollar-denominated sale by an Asian company.

• Oak Hill Advisors is leading a debt package of approximately $1.4 billion to help finance Advent International’s proposed purchase of a stake in Prometheus Group.

• Banks plan to hold a bond sale as early as next week to help pay for Roark Capital Group’s acquisition of the Subway restaurant chain.

• Peloton Interactive Inc. sold $1 billion in loans, securing more favorable terms after the deal gained traction among investors.

• Seafood restaurant chain Red Lobster has filed for bankruptcy, succumbing to onerous leases, high labor costs and a disastrous, unlimited shrimp promotion.

• A lender to utility company Thames Water intends to offload around £500 million ($635.5 million) of the company’s loans.

• Chinese companies have reduced several measures of external debt to decade lows or record levels.

• China Vanke Co. has repackaged some of its issued private debt into asset-backed securities, a move that effectively allows the developer to postpone already deferred payments.

• Cerberus Capital Management LP and Intrum AB are in talks to buy a portfolio of about 7 billion euros ($7.6 billion) of European non-performing loans.

In motion

• has hired credit veteran Matthew Humphrey to its multi-asset investment team in London, after he spent 11 years at Barclays Plc, ultimately as head of synthetic risk transfer structuring.

• Bobby Jain’s multi-strategy hedge fund has hired Syril Pathmanathan, until recently at DE Shaw & Co., to lead the synthetic risk transfer investment effort.

• Fidelity International has suspended its direct lending activities in Europe and laid off members of its private markets team.

• Barings has hired Bob Shettle once again as managing director. He will join the company’s North American private finance investment committee starting at the end of May.

• Bayview Asset Management has recruited Craig Schorr as managing director in its insurance asset management division. Previously, he worked at AllianceBernstein as head of North American insurance.

–With assistance from Amedeo Goria.

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