Japan Leading The Way In CLOs, 2019 Observations
The first quarter of 2019 is coming to an end and after a bumpy end to 2018 we did not expect to see a lot of issuance of new CLOs once the pipeline had cleared. But although CLO debt remains expensive for equity investors (arbitrage has only gotten worse as the leverage loan supply is still slow) there seems to be no end to new deals coming to the market. There are a few things that for us as debt investors stood out; the strong Japanese bid for AAAs, structural differences, varied pricing and spreads that have not recovered as quickly as for similarly rated corporate bonds.
The Japanese bid for AAAs remains strong and there are no signs of them pulling back anytime soon. After a very slow January, with just 1 new CLO (managed by CSAM) another 14 transactions came to market in February and March, of which just 1 refinancing, bringing the total volume to €6.4bn, with another 3 deals in the pipeline looking to price this week. 10 out of 15 CLOs had the AAAs anchored with Asian investors, the Japanese Norinchukin Bank (Nochu) was named by Bloomberg and the FT specifically. There are pros and cons of their involvement for both equity and debt investors. Getting Japanese investors involved is a long process and they have a long list of stipulations (good for all bondholders) that the deal documents have to contain, but they do have a strong bid, and equity investors need that at the moment as arbitrage is far from ideal. AAAs have priced in a range of 108 to 116bps over Euribor (away from 1 short refinancing at +97), which doesn’t look like much but at 10x leverage it makes a significant difference for equity investors. For other AAA investors this has meant that there was very little AAA supply of the so called Tier 1 managers as the Japanese investors typically take 100% of all the bonds available.
Structurally we have seen managers stretch ratings to the limit, but on the flip side the majority of single B tranches were mostly retained or not even structured as it made no sense to issue debt at the same or wider yield than the equity. Minus ratings have been the norm for BBB/BB/B rated bonds so far in 2019. As most readers will know, we are not a fan of these bonds as structural protection and liquidity is worse than for example 2016/2017 transactions. The only manager bucking that trend was Hayfin Capital who brought the first bonds with “flat ratings”, adding almost 2% more subordination at the BBB level. This was well received by the market and the bonds traded 25bps tighter than the Pinebridge deal that priced on Friday, which was rated BBB-.
CVC refinanced their 2014 CLO (Cordatus 4) and issued a rare short CLO with just a 2 year reinvestment period. It will be interesting to see if more managers go down this route, I think that there is definitely a market for these shorter bonds at this stage of the cycle. Execution across deals has, in general, been mixed and we are seeing an increased level of tiering between managers. The widest range we have seen was at the BB level with CVC pricing their BB at Euribor +635 and GSO at +740. However, current general levels in primary today seems to be around 380-390 spread for BBB, up to 925-950 for single B rated bonds.
After a challenging last quarter of 2018 for all asset classes, we have seen HY corporate bonds recover significantly in the first quarter. The XOVER index has tightened by almost 100bps to ~270bps of credit spread, showing this strong rally in European sub-investment grade corporate credit. CLOs have lagged this trend, however, more recently we have seen BBs regain about 40-50bps of spread compared to the start of the year, but Investment Grade bonds have only tightened by around 10-25bps. CLOs still look cheap versus mainstream credit, it should have more room to tighten from these levels and further tiering between managers, ratings and vintages is a good development.