CRIMSON

Structured Credit - Europe

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2021 February

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A continuation of optimism over the recovery and reflation were the dominant themes in February. This resulted in a rise in yields and curve steepening with the US 10Y Government (benchmark) bond seeing intra month highs of around 1.52%, and rates markets in Europe selling off in sympathy on a rise in inflation expectations. This punctured some parts of the equity markets, especially in the technology related winners who have benefitted from lower long-term interest rates and the “stay-at-home” directive brought on by the pandemic. These corrections feel healthy given the frothy earnings multiples these companies had reached. While rising rates have created some market turbulence (including the credit space), they are reflective of an economic expansion to come and should be viewed in a positive light from a fundamental economic performance perspective; certainly, as vaccination campaigns continue to ramp up and Covid-19 related restrictions are lifted towards a gradual reopening.

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While we do expect some short-term inflation pressures driven by (i) the unwinding of pent-up demand, (ii) high savings balances, (iii) supply chain issues and (iv) higher commodity prices, the secular trends that existed before the pandemic still remain, with output gaps remaining high and employment by most measures far below pre-pandemic levels worldwide. Any spikes in inflation, therefore, should be fairly temporary in nature and regarded as less of a longer-term concern overall. Fiscal policy is also still expansionary, with furlough and government backed loan schemes remaining in Europe and the US Congress set to approve more substantial fiscal easing as part of the new administration’s policy platform. Given recent messaging, we would also expect Central Banks to act quickly to temper any signs of a “taper tantrum” or premature tightening in financial conditions that could choke a labor market recovery to the extent it happens.

February was a very busy month in both primary and secondary for European CLOs. Spread compression in CLO liabilities has led to a substantial amount of supply in both new issue and refinancing/restructuring transactions. Indeed, February saw a new monthly record of EUR 3.3bn for new issue supply. Spreads were tighter month-on-month for the senior part of the capital structure, but further down the stack there were signs of market indigestion and spreads leaked wider. We welcome this volatility lower down the structure as it can create opportunities that are technical in nature rather than anything related to credit fundamentals – meaning attractive entry points can be found. Primary transactions became a little harder to place given not only the higher supply, but also interest rate volatility reducing the floor value of CLO liabilities. The floating rate nature of both CLOs and their underlying leveraged loans is supportive for the asset class as the recovery precipitates reflation and a rising interest rate environment over the medium term.

Overall, we expect a continuation of the supportive trends experienced in credit markets so far this year. The backdrop of vaccinations ramping up, gradual economic reopening, and government and monetary stimulus provides a positive tailwind.

2021 January

January was an interesting month for global markets, with US equities flirting with all-time highs but pulling back towards the end of the month. Europe was more mixed, as credit indices drifted wider (XOVER +28bps) though remaining significantly tighter than even just a few months ago as sentiment remained broadly positive. Some signs of exuberance were exhibited in sectors such as technology and cryptocurrencies, but this seems unlikely to have material impacts on overall economic performance. Cyclicals and commodities such as oil continued to climb on tighter supply and expectations of demand on economic recovery taking hold later this year. The anticipation of higher inflation and fiscal deficits (for example, from even larger fiscal spending plans by the new Biden administration) resulted in a steepening of the yield curve, pushing longer-end interest rates higher.

The spread of Covid-19 continued apace in January, with new variants, tighter lockdowns, higher hospitalization, and mortality rates leading to what is likely to be one of the darkest months of the pandemic. Counteracting this, however, the vaccination drive kicked into gear – with the US and UK ramping up significantly. Europe lagged due to production and delivery delays, but overall, there appears to be hope that in the first half of the year the developed world can go some way into suppressing the pandemic (even with the background risk of vaccine unfriendly mutations). Against this backdrop there was no indication that fiscal and monetary easing was going to be let up any time soon, even with market implied probabilities of higher inflation increasing. Central banks indicated their highly accommodative monetary policies would remain in place for a significant time to come.

The start of a new year is usually busy in the CLO markets, and this year was no exception with secondary activity being pronounced across the capital structure (EUR 1.3bn in secondary bid list volume; EUR 3bn across primary and refinancing). Equity distributions were strong during the month, which generated higher volumes in terms of secondary trading flow (and where we participated actively). Senior spreads tightened further, feeding into equity valuations as restructuring scenarios began to be priced in ─ these factors, together with increasing NAVs to the equity tranches, led to multiple point increases in terms of price action. CLO mezzanine tranche spreads tended toward 2020 pre-pandemic tights and, despite higher levels of supply and a mixed picture in broader markets, there was unambiguous demand coming through for CLOs. Primary CLO issuance started to kick into gear too, with the pipeline of refinancing and restructurings continuing to grow as spread tightening increased optionality. Going forward we could expect this heightened primary/refinancing supply to throw up tactical trading opportunities in the event of supply/demand imbalances.
 

2020 December

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Markets continued to recover in December as sentiment remained positive. Despite the setback before the holidays of renewed lockdowns and restrictions being put in place across Europe as the virus infection rate picked up, together with record high infections in the US, the market remained bullish taking comfort from the vaccine roll out, continued fiscal and monetary support worldwide, strong growth in China helping manufacturers and some of the short-term political risks receding. The discovery of more contagious variants to SARS-CoV-2, illustrated how any emergence of new strains should be watched with caution – particularly in regard to transmission and influence on vaccine efficacy. Despite this risk, however, the most likely result would merely be a prolongation of the vaccination rollout while vaccines are modified (to the extent this is even required) rather than any nullification of efficacy. As such, even if an “escape mutation” does transpire, a market shock of anywhere near Spring 2020 type magnitude seems unlikely.

After nearly four years of political drama and three UK Prime ministers, there was at long last a Brexit deal agreement at the last minute before the Christmas holiday (and ratified just before new year and the end of the transition period). This narrowly avoided the “cliff edge” scenario with tariff barriers being erected overnight and an immediate inflationary supply shock.

Customs checks remain, however, and there is yet to be a deal agreed over services which makes up the larger part of the UK economy. From a markets perspective the reaction was positive with a direct impact on European credit – the tail risk of a ‘no deal’ having been removed and portfolio reallocation flows into the UK likely to buoy sentiment into 2021.

The final month of year was busy for primary European CLOs, with EUR 1.7bn of issuance across five transactions. This contributed to a total issuance for 2020 of EUR 22.1bn, whilst this is down around 25% YOY, remains impressive given the scale of market shock and the shutdown of CLO primary market in Q2. It is worth noting, even with the movement in CLO spreads over 2020, there has been virtually no refinancing or reset activity post the onset of the pandemic. We expect this to change significantly in 2021 as liability spreads continue to recover and the embedded value accretion to Equity becomes more evident. We are also already aware of a sizeable pipeline of new deals coming to market for H1 2021, which should also be met with more loan and high yield supply as investors look to the end of the pandemic and economic recovery.

2021 Outlook

2020 will be remembered for decades for the Coronavirus pandemic, but we will not dwell here on all of the “once in a century” type headlines which we are sure our investors are more than familiar with. Instead, we look forward to a future where several different paths to recovery may transpire, so being both agile and tactical on positioning will be important factors. As such, while we believe in the “V-Shaped” recovery at a high level, we do not necessarily believe it will be a smooth, inexorable path. There will be wobbles, bumps, and highs and lows along the way; all of these we welcome as they play to our strengths in trading and speed of fundamental and structural analysis. Our expectations center around a bottoming of growth in Q1 after a difficult winter, followed by a normalization from Q2 onwards as economies reopen and the medical solution via vaccines becomes more entrenched; we then expect the recovery from Q3 onwards to be accelerating and led by a significant demand impulse. Underpinning this path to recovery will be accommodative central banks and governments maintaining a high level of fiscal support, both likely to provide a boost to output for quite some time as the recovery consolidates.

We believe CLOs are past the worst with respect to loan downgrades, expecting loan defaults within CLOs to remain contained (1-3% range) and trend lower by the end of 2021. Indeed, the very low level of defaults (in several cases zero) achieved by some managers in Europe has been a standout upside surprise. With an end to the pandemic in sight, viable businesses have and should continue to be able to raise fresh liquidity in the capital markets to bridge short-term cashflow disruption. Some loan credits will, of course, continue to be challenged in the tails of some CLO portfolios, but here the close synergies with our Special Situations team enables us to have a clear sense of credit risk and therefore a source of alpha to the extent we see tail risk as mispriced in either direction.

The intrinsic option value embedded in CLO equity is characteristically non-linear and appears to us to undervalued by the market at this juncture; in certain profiles this looks to be very significant. In addition to this, Event Driven upside will reemerge as a significant driver of returns through 2021 and beyond, with this segment of the Fund having been entirely dormant and priced to zero through 2020. Call situations, refinancing and resets of transactions should become a feature of the market through 2021 – with the significant structuring, analytics (accompanied by our own proprietary systems) and execution expertise within our team, we feel very well placed to capture the latent upside potential that exists in this segment.

Demand for CLOs should grow as economic conditions normalize and the monetary backdrop drives a hunt for yield in an asset class that proved its resilience again while riding out the coronavirus pandemic. Additionally, the ability of this floating rate asset class to provide protection against a rising inflation and interest rate backdrop will not go unnoticed for too long.

The pandemic has also re-calibrated the risk/reward in other select asset classes in the ABS and structured credit space. These may provide opportunities for us throughout the course of 2021. The depth of experience in our firm enables us to have the skillset to analyze these and extract incremental value.

Interestingly this time around, the intense media culture prevalent today probably assisted in our trading into significant mispricing of CLO tranches during last year given a fundamentally misguided understanding of the asset class often being perpetuated by pundits and headlinemakers. We hope they keep talking.

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2020 November

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The market inflection point we have been discussing in several previous newsletters looks to be fairly evident from November’s market moves. Indeed, it is likely to be remembered as a key turning point for the global economy and markets on several fronts. Firstly, the month started out with the US election – a key risk event for the year which came and went without too much widespread disruption. Joe Biden was successful and won by multiple states – reducing the risk of a messy “contested election”. However, despite the Democrats winning the Presidency, it is looking increasingly likely that the Republicans will control the Senate (pending Georgia runoffs in January 2021). This presents somewhat of a Goldilocks scenario for markets, with new administration being overall more constrained in being able to push through some of the more business/market unfriendly policies that some Democratic politicians have been championing during the campaign. 

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Secondly, and more importantly in our view, there were key developments on the medical front in the fight against Covid19. Not one, but three vaccine candidates published trial results showing very high levels of efficacy, with two of them greater than 90% - far above expectations. The importance of these developments for the global economy and markets cannot be understated. While the disease continues to spread, cases at record highs, recurring lockdowns, and the logistical challenges faced with vaccine distribution – the discovery of working vaccinations means that there is an end to the pandemic in sight. Given risk asset prices are a function of forward expectations, the market staged a significant rally on the news and optimism continued through the month. Cyclical and COVID-sensitive sectors benefitted the most from the start of this rotation, outperforming the “stay at home” trade. With normalization in sight, this should make it easier for corporates to plan ahead and raise any necessary extra capital to maintain operations through the remainder of the pandemic.

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European credit markets were a large beneficiary of the newfound optimism, particularly given the region’s more cyclical and trade-oriented bias. XOVER tightened by 104bps over the month. The backdrop for credit looks favorable in a world where there is an end to the pandemic in sight and at the same time significant twin supports via monetary and fiscal stimulus likely to remain in place for potentially years to come (despite some holdups on the fiscal front on both sides of the Atlantic). Furthermore, inflation remains very low and a significant output gap remains.

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CLO markets were a significant beneficiary of the rally, with underlying loans higher by multiple points – feeding through into Equity NAVs and market value coverage metrics. So far, it looks like the CLO structure is coming through yet another stress test and performing as advertised: despite a huge shock, there have been low defaults (whereas pickup of defaults rates in the headline indices is occurring), little cashflow diversion and ultimately a recovery in market value. This recovery still has room to run lower down the capital structure; given the changing macro environment we expect this to be realized over the coming months and well into 2021. Indeed, with much of the fixed income universe in zero/negative yielding territory and the significant basis between corporate debt and CLOs for a given rating, the relative value proposition should provide strong technicals to the CLO story.

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We expect the road ahead will present multiple opportunities in primary and secondary markets, including the re-pricing and realization of dormant event driven opportunities, which we believe should unlock significant value as debt spreads continue to tighten. We remain mindful of the pandemic still not being over and have positioned to take advantage of any pockets of volatility as Covid-19 infection rates inevitably rise post the Christmas/Year-end festivities and some event risk (read Brexit) remains a factor.
 

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2020 October 

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Markets had an optimistic tone over first half of October, though this soon evaporated as new lockdown measures were announced across Europe. Major European countries such as France, Germany, Spain and the UK saw large rises in Covid-19 infection rates. Governments reacted by reintroducing lockdowns, although these were not as strict as before and more targeted around closures of hospitality while keeping schools and workplaces open.

Expectations around the impact of these measures and their associated economic cost pushed broader markets lower over the month, with XOVER wider at +24bps month-on-month (+62bps from its intra-month tights) and major equity indices lower in the range -2% to -10%. 

The US election entered its endgame, with polls continuing to show a large lead for Joe Biden nationwide – but with evidence of tightening towards the end of the month. Swing state polls remained generally a lot tighter than the national average as well. Rates sold off somewhat as markets weighed the prospect of a “Blue Wave”– leading to large fiscal stimulus and a reflationary environment. These moves came against a backdrop of continued loose monetary policy and a worsening pandemic, so were not dramatic. Brexit talks continued to drag on and Sterling was volatile as the month progressed with conflicting “will they, won’t they” headlines as the two sides entered their final stretch of talks. 

Q3 economic data showed record levels of growth across Europe and the US as countries reopened their economies. This, of course, came after a record collapse in the previous quarter, and GDP levels remain below where they were at the start of the year. Furthermore, these are backward looking measures – fresh lockdowns should dampen fourth quarter growth, especially in Europe given its tendency to cyclically lead Covid-19 infection rates (both up and down) versus the US. PMI survey and consumer confidence data offered some insight into the slowdown to come, especially in the service sector where the effect of lockdowns and social distancing is greatest. This time around, however, the lockdowns have not been as severe – thereby cushioning the market impact somewhat, not to mention the ongoing presence of significant fiscal/monetary support and many businesses actually remaining open or having adapted (e.g. manufacturing and construction). October was a strong month for new CLO issuance, with EUR 4bn of primary deals printing in Europe – the highest month of new issuance year-to-date. Euribor moved deeper into negative territory, increasing the value of the interest rate floor embedded within CLO profiles.

Price action in secondary mezzanine lower down the capital structure was light through October, with spreads basically flat until the end of the month where macro pressure from increasing Covid-19 infection rates weighed on valuations. On the other hand, CLO Equity activity was more buoyant as the October payment cycle helped increase trading flows. Principal coverage cushions improved, and equity distributions rebounded from levels observed in April and July. This combination of realized cashflows exceeding expectations and improving performance pushed the ‘catch up’ of CLO Equity further along the road. Indeed, fundamental credit metrics in European CLOs continued to improve as the percentage of deals failing overcollateralization tests fell, equity distributions continued recovering and CCC concentrations also fell. While realized loan default rates ticked up at the index level, they remain far lower in CLO portfolios generally speaking, highlighting the value-add of CLO managers (some more than others) via credit selection and trading. The fund returned USD +1.26% on a net basis in October.

The tug-of-war between renewed lockdown fears in the near term versus an increasing proximity to potential vaccine(s) and therapeutic announcements has caused the market to become range bound. That said, this facilitates trading avenues and provides opportunity to play into both volatility (read Covid-19, US Election, Brexit, etc) and any possible inflection point in markets.
 

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2020 September

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Early September optimism, with US equity indices hitting new highs, quickly evaporated with a resurgence in virus-related concerns worldwide and little progress on fiscal stimulus talks in the US. Broader markets across both equity and credit (XOVER +29bps) ended up lower by the end of the month, especially COVID-19 sensitive sectors as new localized lockdown measures were announced in Europe against a rise in virus infection rates. Despite this, hospitalization and mortality rates remained contained and far below their spikes at the beginning of the pandemic.

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The US election campaign continued to heat up, with a fiery presidential debate at the end of the month, as well as the prospect of a new Supreme Court justice causing further contention. Polling data continues to show Democratic nominee Joe Biden with a nationwide lead – but as ever it comes down to the swing states in determining the final outcome. Given the large number of postal votes, there remains the risk of the election result not being known for an extended period. Unsurprisingly in Europe, Brexit negotiations continued to make little headway, with key differences between the EU and UK around fisheries and state aid remaining unresolved. Brexit and COVID-19 will no doubt be high on the agenda when EU leaders meet for their summit in October.

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There was evidence in economic survey data that the post lockdown “bounce” in Europe was running out of steam, with PMIs mixed across sectors and economies in Europe. Services, which tend to exhibit higher COVID-19 sensitivity, underperformed versus manufacturing. Inflation continued to slow with some readings turning negative, underscoring the need for enhanced stimulus measures to continue for the foreseeable future. Despite a record amount of QE, the risks seem more skewed toward deflationary rather than inflationary pressure. In the US, unemployment continued to fall but at a slower pace.

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September saw new issue European CLO transactions pricing at post-COVID tights. A total of four new issue deals were brought to market and priced in September, with strong demand across the risk curve. Despite a softening in debt spreads towards the end of the month in line with wider market volatility, elevated supply in secondary was absorbed quite efficiently by CLO market participants. European credit markets generally appear to be range-bound as investors grapple with rising virus infection rates and political event risks offset by persistently low interest rates, unprecedented government support and building optimism around the timeline for medical solutions to the pandemic.

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Market value coverage ratios for European CLO tranches improved, driven by shrinking portfolio “tails” as the proportion of lower priced loans declined given a combination of price appreciation and manager trading. CCC metrics and OC tests remained fairly consistent following the easing in ratings downgrade pressure and manager trading around CCC buckets. Given the improvement in underlying fundamental performance and lowering default rate expectations, rating pressure also continued to abate at the CLO tranche level; ratings across the capital structure were affirmed after previously being placed on review for downgrade. The quantum of rating downgrades during this year’s period of stress in Europe is about half that of the US, and the recent rating activity in the US has been skewed towards downgrades whereas in Europe it has been towards affirmations. Indeed, the realized default rate for this year in European leveraged loans is tracking at around half of the level observed in the equivalent US market.

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Looking forward we expect volatility to remain elevated into Q4 given the event risks present in the macroeconomic backdrop. With most asset classes having now retraced the majority (and in many cases all) of their losses since the onset of the pandemic, structured credit remains fundamentally cheap and a resolution in even one or two of the macroeconomic event risks could prove to be an inflection point in terms of risk/reward.

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2020 August

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Historically one of the quieter months of the year, August saw an impressive rally across financial markets. US equity indices reached new highs led by technology companies, seen by many as the primary beneficiaries of the pandemic and the associated change in consumer behavior. The Federal Reserve aided proceedings by indicating they are comfortable with inflation running above their 2% target (averaging 2% over the long run), signaling that monetary support can continue for a long time as a result of the pandemic. The US election continued to kick up a gear, with Joe Biden leading Donald Trump in the polls nationally but market-implied odds and polling data from swing states indicating that the race is much closer. Volatility futures for November pointed to a high level of event risk regarding the outcome, with both a possible contested result as well as a potential sea change in policy direction on the cards having both business and market implications.

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COVID-19 cases started to rise again across Europe, largely as the effects of “opening up” come through, but also due to increased testing capacity. The pandemic continued to accelerate through India and the Americas, building up Emerging Market stresses both now and down the line. However, as a more positive sign, deaths in Europe remained low and economic data has also continued to improve; albeit decelerating from the initial reopening “bounce” felt in July.

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Corporates continued to post better-than-expected results, and credit markets in Europe ground tighter with the European Leveraged Loan Index (ELLI) average price moving into the 94-handle range (up from lows in the 70’s during March), and XOVER tightening more than 50bps.

Headline inflation in Europe posted a negative monthly reading, giving more weight to fears of deflation – with commensurate implications for monetary policy, which as a result will remain favorable for structured credit for years into the future. The Euro continued to appreciate against the US dollar, both a signal of confidence in the Euro Area, but again another factor keeping the ECB in play given their recent musings around currency strength.

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CLO fundamentals continued to improve through August in terms of both credit and price action: (i) the aforementioned loan rally led to an increase in Equity NAVs and market value coverage for debt tranches, and (ii) CCC/Caa buckets fell with underlying corporate ratings on a generally stable to improving trajectory. Despite the improving backdrop and stronger underlying fundamentals, we believe CLO Equity is still lagging the rest of the CLO capital structure. With CLO debt spreads getting closer to their pre-pandemic levels, the yield basis to Equity seems highly compelling. The market naturally exhibited a bias towards the cleanest profiles during August, but we expect this to change over time as further clarity around the credit effects of the pandemic gives market participants higher confidence around pricing scenarios.

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Realized defaults rates in Europe continue to trend higher given the passage of time since the beginning of the pandemic, but even so they are only around their historical averages in Europe, or roughly what a pre-pandemic “Base Case” would have been. We have been working closely with our European Special Situations team on several credit intensive situations/restructurings within our CLO portfolios in order to gain comfort (or not, as the case may be) to further refine trading decisions at the CLO tranche level.

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Primary CLO supply slowed in August as is usual given the time of year – only two new issue deals were printed in Europe. In the secondary market trading volumes in Europe also dropped and CLO debt spreads largely traded sideways, but we began to see some reasonable moves in cleaner CLO Equity profiles given the improvement in fundamentals mentioned earlier. Looking forward we see several new issue deals coming to market, including some key strategic situations we are involved with where we expect the opportunity to build long-term value to be significant.

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Overall, our expectations are for volatility to rise through Q4 given political risks (read US Election, Brexit deadline to name just two) and COVID-19 infection rates inevitably increasing given the easing in ‘Lockdown’ conditions.

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However, we expect this rise in volatility to remain contained given the sheer level of central bank and fiscal support, together with the increased proximity of a vaccine being possibly proven effective and ultimately becoming available. This type of landscape will no doubt provide an ample opportunity for mispricing, for which we believe we have the combined structured and corporate credit skillset to take advantage of.

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2020 July 

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Financial markets were mixed in July, with many indices basically flat to higher and the US outperforming despite the epidemiological and geopolitical backdrop. The COVID-19 pandemic and the associated fiscal/monetary response continued to dominate the market’s attention. Viral infection rates rose across in the “Sun Belt” states within the US, and there were small signs of resurgence in some parts of Europe. Despite this, we maintain our view that it is unlikely there will be more national lockdowns of the scale seen earlier in the year. The US and China “Punch and Judy show” continued with further sanctions, consulate closures and pressure on specific companies (e.g. “TikTok”) all ratcheting up both tension and market worry during the month.

Corporate earnings season came out better than was feared, and there was an overall increase in signaling out of major economies that the worst may be over from an economic perspective. The US Dollar also fell significantly against the Euro over the course of July given both the (real) rates backdrop and perception that Europe’s response to the pandemic has been more effective and cohesive compared to that of the US.

Investors got a sense of the scale of the economic damage with Q2 GDP data across much of the developed world being released; figures averaged around 9-12% down quarter-on-quarter. While largely anticipated, this is expected to be the trough as reopening continues and society adapts to protective measures against the virus. PMI survey and high frequency data point to a rebound through Q3, and US jobs numbers also highlighted some improvement.

CLO fundamentals improved in July, with CCC buckets falling, WARFs (Weighted Average Rating Factors) coming down and Overcollateralization (OC) tests improving generally. The drivers behind these were improvements in both price and fundamental performance of weaker credits in CLO portfolios, a slowdown in rating downgrades and managers’ trading actions ahead of the July payment dates (where a large proportion of European CLOs pay out distributions).

The dichotomy between the European and US CLO markets continued, with only 2% of European CLOs failing an OC test versus 17% in the US in July.

Cashflow performance of CLO equity positions in the portfolio exceeded our expectations, as all positions with July payment dates made distributions to equity. In the couple of cases we had expected to be marginal, manager trading action made a decisive difference.

July also marked the strongest month since the onset of the pandemic for Euro CLO primary issuance, with 8 deals pricing for a total of EUR 2.6bn. That said, AAA spreads remain historically wide, and the refinancing/reset market remains a long way from returning. In the secondary market, liquidity was strong with significant amounts of both dealer run and auction activity – this appears to have been absorbed well with no meaningful spread widening in lower mezzanine tranches. Credit quality naturally remains a focus with perceived ‘weaker’ tranches generally trading materially wider.

Trading volumes (10%) were higher in July, as we took advantage of some market inefficiency by adding more convex profiles and repositioned some risk by moving up in credit quality through trading switches across the capital structure. Furthermore, we realized event driven return from a longer-term strategic ABS CDO position that had been a play over several years – providing a source of uncorrelated returns.

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Asset pricing largely moved sideways over the month, but going forward we expect spread tightening from further fundamental improvement as the economic recovery continues in Europe aided by continued policy support. There should also be technical tailwinds as real money buyers begin to re-enter the higher yielding CLO and ABS space through the end of Q3 and into Q4 as markets continue to normalize. We remain vigilant regarding the economic recovery and maintain a tactically cautious footing.

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2020 June

In line with expectations, the ongoing Covid-19 crisis continued to dominate sentiment through June – with major equity indices rising slightly but largely flat over the month, albeit with reasonable volatility throughout the month. The iTraxx Crossover index tightened more than 40bps over June as investors became more comfortable with the path of reopening in Europe – but like equities the index was volatile over the course of the month. The intra-month moves at the index level highlight the tension between optimism around ongoing stimulus measures and reopening of major economies leading to an uplift in economic activity, versus the risks of a possible “second wave” of the virus, especially in the US, as well as large outbreaks in the developing economies of India and Latin America. Rising political and geopolitical risks (US-China trade tensions, Hong Kong’s security law, US elections, Brexit, to name a few) only appear to have a marginal impact on markets at present – at some point this should change if and when the virus takes more of a back seat.

Economic data generally showed signs of improvement as lockdowns continued to be lifted, and most survey data, while still in “contraction” mode, continued to come off the lows seen in prior months at the height of the crisis. In Europe retail sales data in many countries showed considerable improvement indicating evidence of pent up consumer demand. In the US jobs data showed an impressive “bounce back” with non-farm payrolls defying expectations of increasing job losses with an unexpected fall in the unemployment rate as states reopened businesses and people were rehired into industries which had been previously shut down. However, this move has come with rising Covid-19 cases – so there remained anxiety around the path of the virus going forward and what the effects of more localized lockdowns would be. We do not expect there to be nationwide lockdowns again even as cases rise – they should be more targeted in nature, i.e. at the individual city, state or province level.

Policymakers and healthcare providers will also be much more prepared this time around with appropriate PPE, social distancing measures and ever improving treatments to deal with any further spikes – so we do not expect a return to the lows of March from a market pricing and liquidity perspective.

Generally, the consensus view is that economic activity and corporate performance should improve from here, although with some degree of scarring and with clear winners and losers. Our internal view has remained more nuanced at the second order level of underlying CLO credits, where we see a combination of winners, losers and survivors, with the latter segment being both underappreciated fundamentally and mispriced in the structured credit markets. Naturally default rates have picked up in the credit markets, but are not yet materially elevated despite the crisis – many companies have been able to raise new money from capital markets/sponsors or benefit from government schemes to help manage liquidity through the shutdowns. Indeed, many are back up and operating at close to pre-crisis levels to the extent possible. Notably the median ‘defaulted asset’ bucket in European and the US CLOs remained quite significantly below the headline loan index level, demonstrating the value of CLO manager action. In the European CLO space market value related metrics such as CLO equity NAVs and tranche MVOCs continued their improvement over the month as loan prices stabilized, with commensurate spread tightening down the CLO capital structure. Despite ongoing concerns around the spread of the virus, rising geopolitical issues and poor economic data, CLO and corporate credit markets appear to have come a long way from the liquidity driven collapse in March and continued to show signs of stabilization. Furthermore, the primary CLO market continued its own “reopening,” with 9 deals for a total of EUR 2.4billion pricing in June. However, on a relative value basis we still consider secondary to be at a more attractive entry point.

We took advantage of growing liquidity to rotate out of some more credit sensitive and less strategic profiles, as well as add convexity and source more strategically placed profiles which we know in depth and that we believe have room for considerable upside. We maintain the view that there is still a significant amount of dislocation in the CLO market, and that volatility will continue going forward giving rise to further trading opportunities.

Notably CLO equity also continues to lag both broader market moves and the rally higher in the CLO capital structure; we believe this segment of the portfolio offers latent potential in an area that remains difficult to source in terms of both quality and size.

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2020 May  

Markets continued their positive tone throughout May, looking past the immediate effects of the pandemic and dismal economic data. Equity and credit markets trended further upwards from their March lows, with XOVER grinding c. 90bps tighter month on month and major equity indices rallying against a backdrop of further lockdown easing measures and more government and central bank support. Furthermore, the accelerating hunt for medical solutions, increased understanding of the severity of the disease and falling infection rates across much of the developed world underpinned this sense of optimism.

These positive impulses overwhelmed growing political and geopolitical tensions, as well as grim GDP and employment data. The US-China trade war and general acrimony between the superpowers resurfaced as Beijing moved to increase their influence in Hong Kong, with the US threatening to retaliate through economic sanctions and end their “special trading relationship” with the city – risking retaliation from China who see it as an internal affair. Other developed countries such as the UK, Japan and Germany, and indeed Europe as a whole, are also starting to show signs of re-evaluating their relationship with the world’s second largest economy. At the end of the month political tensions flared up in the US and there was widespread rioting across most major cities just as businesses emerged from the lockdowns.

Q1 GDP figures released in May showed the initial impact of the lockdown, with most developed economies contracting around 4-5%. Given that the lockdown peaked in the second quarter, the next round of “hard” economic data is expected to be even worse. Retail sales data released this month for April showed a collapse as shops were shuttered across the developed world, but this should begin to reverse albeit at a slower pace than the drop. Unemployment in the US spiked to c. 15% in April and is expected to continue to rise. Employment data was more constructive in Europe – increasing numbers of people unemployed but not to the same extent as the US.

This dynamic should help European recovery prospects (as people receive income from government furlough schemes and keep their jobs during lockdown) and mitigate political risks and risk of civil unrest borne of economic crises. Europe appears to be reacting much more effectively to this crisis than in the past, and the ECB has managed to keep government bond spreads constrained despite the obvious spike in levels of government debt.

The loan market continued to rally from its lows as risk appetite continued through May. In addition, the pace of Rating Agency downgrades decelerated and some of the “tail” type names most exposed to the pandemic’s fallout improved on better than expected results and news of access to sources of liquidity. As a result, market value coverage metrics improved for CLO securities in May, even given the increased pressure on covenants/tests. European CLOs continued to outperform their US counterparts on a coverage test basis – only one European CLO failed an Overcollateralisation (OC) coverage test as of the end of May (c. 0.3% of EUR CLOs), compared to c. 23% of US CLOs (resulting in cashflow diversion away from more junior tranches). This is largely because CCC downgrades and defaults have been far higher in the US, in line with our longstanding fundamental thesis on the comparative advantages of European CLOs. Primary CLO supply ticked up, with EUR 1bn of new issue deals printing in May – although we continue to believe secondary remains far more compelling at this juncture.

In line with historical experience, CLOs have lagged the upward price action the underlying leveraged loan/HYB markets, but finally started playing catch-up in May. Lower mezzanine tranches were well sought after and staged a rally. The dramatic improvement in liquidity encouraged more investors and dealers to become involved, especially under the continuing backdrop of improving macro conditions. CLO equity has been the notable laggard in this recovery, despite the upside to cashflow distributions and embedded optionality from this price point offering a compelling return potential.

We selectively added a few higher quality profiles during the month, taking advantage of still distressed levels where we saw good recovery potential, and rotated out of a few of names where our re-underwriting process had revealed potentially higher credit risks under a post COVID-19 state of the world. We also reduced hedge positioning earlier in the month as market signals indicated the stabilization was sustainable, in line with an easing of lockdown conditions and gradual re-opening of economies.

We believe this to be start of a recovery which should see further spread tightening in the near term, with much of the portfolio providing high levels of total return potential – and the possibility of this being realized sooner than anticipated two months ago.

Overall, and barring a large second spike in COVID-19 infections, our view is that the recovery should be much quicker than past crises, with central banks and governments offering unprecedented liquidity and fiscal support to the economy for the foreseeable future. A large amount of money has been (and is being) raised to take advantage of the dislocations which have occurred as a result of the “Great Lockdown,” adding a technical tailwind to support credit markets, although access to the better assets in structured credit/CLOs appears to be more difficult than they expected for these accounts. The prevailing investment opportunity set brought on by this crisis remains large and has a long way to run. Broader market stabilization has only highlighted the convexity and return opportunities available.

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2020 April

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April offered some reprieve for many financial markets across a backdrop of increasing intervention by monetary and fiscal authorities to contain the economic fallout from the pandemic and more clarity around the end of the government mandated lockdowns. Covid-19 continued to spread but increasingly investors began to look beyond the initial shock and instead began responding to the monetary and fiscal support measures that either are in place or being anticipated. In addition, many European countries began to set out their framework and timelines for a gradual reopening of the economy, which lifted spirits as it offered some insight into a possible way out of this crisis.

In the commodity markets, the oil price war followed by collapsing global demand created large downward price pressure. Reflecting the unprecedented nature of current times, the front WTI contract traded at a negative price in April as supply vastly outstripped demand. These dynamics should limit forward looking inflationary pressure, allowing considerable runway for central bank action to take effect.

The US Federal Reserve ramped up support for credit markets through the announcement that they would buy ETFs backed by high yield bonds (so supporting lower rated credit), as well as expanding their TALF (Term Asset-Backed Securities Loan Facility) to include an increasing number of assets in the securitization market that can be held as collateral, including a segment of the AAA rated CLO universe. We see these increasing levels of market support as positive and should boost liquidity both in the US and abroad, adding a positive technical to credit markets and improving financial conditions. Against this backdrop, measures of stress in interbank lending have also subsided.

European monetary support is less clear at this juncture, with ongoing debate around the joint issuance of “Coronabonds.” While the ultimate mechanism for support is to be concluded, we see the failure to come to a solution here as not being an option given the economic and political implications of failure. The ECB did, however, leave further rate cuts on the table and indicated further support for the public debt complex of affected countries such as Italy via unlimited QE. Further fiscal stimulus measures are expected to be agreed soon, with more Keynesian style fiscal stimulus likely to follow in order to cement the recovery once some semblance of normality has resumed.

Dismal economic data continued to pile up across the world, with joblessness spiking in the United States and most forecasts predicting severe recession. Sentiment surveys crashed as businesses and households projected weak demand under a “Lockdown” scenario. The length of the coming downturn is much debated, but given the unprecedented policy response and the strength and resilience of the financial sector we believe there should be a recovery or at the very least “green shoots” in the second half of the year. Many of the government schemes in Europe are designed to keep people on the payroll and provide government grants and guarantees to affected industries. While not perfect, these allow for a return to some kind of “new normal” once reopening occurs. The nascent counteracting force to all of this remains the medical response, with both COVID-19 treatments and human trials on vaccines being fast tracked around the world. Increased testing and tracing capability should allow further virus outbreaks to be contained. Liquid stock and credit markets have clearly begun looking beyond the dire economic data and pricing in some portion of these views given the risk rally we have seen over the course of the month.

Bifurcation continued to be a theme for CLO markets, with liquidity improving overall, especially in Investment Grade, but remaining relatively light further down the capital structure. Underlying loans began to recover in price, aside from names in the most obviously affected sectors. High yield corporate markets reopened with larger names being able to tap the capital markets or receive sponsor and/or Government support, even within those sectors deemed “COVID sensitive.” Rating Agency actions in the high yield and leverage loan markets came into focus, though in Europe we have not seen any CLOs breach Overcollateralization (OC) Tests despite downgrades in some of the underlying assets. This compares favorably with the US market, where many more CLOs have had OC test breaches (and hence cashflow diversion) and exhibit a higher degree of stress in the underlying, derived from both COVID-19 and oil/energy sensitive names. We see this as supporting our long-held preference for European CLO exposure, which went into this crisis with an overall materially higher level of OC test cushion.

As the month progressed and broader markets recovered some of their YTD losses, buyer interest in the senior higher rated parts of the capital structure picked up and Investment Grade paper saw a rally. This fed into some tightening in the junior mezzanine CLO space, but we still see these tranches as being extremely mispriced given the levels of subordination and structural credit enhancement, and when looking at the basis to similarly rated underlying loan/high yield markets.

While trading volumes in the strategy remained muted over the month, we did manage to execute some up-tiering in credit quality asset switches, while also selectively reducing risk in a few positions where our re-underwriting highlighted potential credit risks due to the current backdrop.

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The primary CLO market also tentatively reopened with lower levered deals at the end of the month, adding to already positive loan market technicals. Overall, we currently favor opportunities in secondary over primary markets, given the sheer scale of the price dislocation that has occurred. Prices for European CLOs remain at decade lows and the market exhibits a continuing departure from fundamental value, especially given the high margin of safety the asset class provides. More liquid markets are already pushing ahead and looking beyond what is expected to be a dire year for earnings and economic activity. We see substantial room for structured credit to catch up given these moves and our ongoing fundamental analysis of both current and potential positions in the strategy.

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2020 March

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March naturally was dominated by the continued and accelerating repercussions of the Covid-19 pandemic – now spread across much of the developed world in varying degrees. Markets showed considerable signs of stress worldwide in the face of the many uncertainties relating to the pandemic and what the economic fallout would be. Furthermore, the unravelling of the ‘OPEC+’ talks caused oil prices to collapse after major producers Saudi Arabia and Russia instigated a devastating price war on top of a huge drop in demand stemming from the outbreak. As a result, equities and credit took an enormous battering in trading sessions throughout the month, with liquidity drying up in all parts of the market. Even haven assets such as Gold struggled as investors sold to meet margin calls brought on by the spike in volatility. VIX at one point traded higher than during the Global Financial Crisis of 2008/09 (“GFC”) as fear gripped markets and circuit breakers in major equity indices were triggered on the way down as virus related news flow came through thick and fast. Governments worldwide reacted to the Covid-19 outbreak via largescale “Lockdowns,” shutting down large sectors of the economy, generally confining people to their homes where possible to prevent community transmission and keep the key “R-nought,” or reproductive rate of the virus, as low as possible. This, of course, inevitably has major knock on effects for business and economic activity. All in all, the market experienced a crash comparable to that of the GFC, but compressed into a much, much shorter timeframe.

This financial and economic stress was met with swift and unprecedented responses from policymakers world-wide. Central banks such as the Federal Reserve and ECB aggressively ramped up expansionary monetary policies, deploying GFC magnitude responses in a dramatically reduced timeframe. Interest rates were cut, and large-scale QE restarted, injecting significant liquidity into dysfunctional markets. On the fiscal policy side, a raft of measures was introduced to try to manage the real economy through this exogenous economic shock. The US and European

governments drew up increasing tranches of support: providing guaranteed loans to businesses, grants for smaller companies and payroll protection schemes to keep people in work and economically insulated as much as possible – as well as increases in social security and unemployment benefits. Economic and survey data held up through March but mainly because it referenced the previous month and/or was conducted before the worst of the outbreak (and associated lockdowns) became apparent. However Chinese data, where the outbreak started, saw large negative readings. We expect of course that economic data and surveys will be highly negative in the months ahead, this being reflective of the forced shutdown of large parts of the economy, and support will take time to flow through various bureaucracies – but it should in time have a meaningful impact. Markets generally took the announcement of support measures in a positive fashion and headline indices (equities as opposed to credit) generally rallied into the end of the month, easing some of the pressure.

We see the CLO market as being one of the worst affected markets in terms of valuations since the start of this crisis, pricing in a worst-case scenario almost immediately. The very low liquidity in both the underlying loan and the CLO tranche markets led to very few trades apart from distressed sellers, which dragged down valuations way below what we see as fundamental value, even if the Covid-19 crisis were to cause a sustained downturn. Multiple asset sale lists came up for auction throughout the month, with a high level of DNT’s (Did Not Trade) – a sign that sellers were simply not willing to let assets go at these levels, which we see as vindicating the “dislocation from fundamentals” argument.

Throughout March trading volumes were very low – bids generally made little sense in our view and market participants were reluctant to let go of quality profiles given the volatility and lack of liquidity unless really being forced to do so. Despite this we managed to structure and execute a large new issue deal at the start of the month which we see as being very well positioned to take advantage of the current market environment for considerable upside. This was done in exceptional circumstances which we believe is a testament to our ability to manage these kinds of crises. We do expect some fundamental stress in the portfolios we have exposure to, especially with more levered corporates in the entertainment and leisure sectors (although we also expect many of these names to be the beneficiaries of governmental support in due course).

However, we believe a large proportion of the selloff is more technical in nature, with redemption related liquidations in loans coming from SMA accounts and broad based fear leading to distressed sales/capitulation in the loan and high yield space – and that many sectors (for example healthcare

and pharmaceuticals, the largest exposure across European CLOs) will ultimately weather the storm.

CLOs are term-funded vehicles and therefore not subject to these kinds of technical pressures. We also note there is negligible Oil and Gas exposure in the European CLO market and our portfolio – which should make it more stable than the US CLO space overall, given the volatile supply and demand dynamics in the energy market.

In addition, it is worth bearing in mind that mark-downs in price terms are unrealized losses and distinct from write-downs in credit terms, which are realized, and the powerful self-correcting nature of CLOs is often under-appreciated in stressed market conditions when differentiation between asset quality is minimal.

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