Structured Credit - Europe
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
The ongoing Coronavirus outbreak continued to weigh on sentiment throughout February as investors further digested exactly what the supply side effects would be from the shutdown of economic activity in parts of China on the global economy. Despite this, markets were initially optimistic that the epidemic could be contained.
These hopes were dashed as other hotspots emerged in South Korea, Iran and Italy towards the end of the month, with more cases rising steadily worldwide. This sent global markets into a tailspin as the prospect of a global pandemic reared its ugly head with the potential for widespread economic disruption over the world as governments, consumers and businesses are being forced to adjust their behaviour. With the world economy possibly facing both a large demand and supply shock, credit and equity markets began to freeze as investors headed for the exits, and rates began their inevitable march lower in the face of unquantifiable uncertainty.
Economic data generally held up through the month of February, but given the potential fallout from the spread of the coronavirus it is hard to read into it from a forward looking perspective, as many of the releases are either backward looking or survey data collected before it began to show real signs of spreading outside China. On the other hand, it provides a reasonable base from which to assess an exogenous economic shock such as the spread of a novel virus and the related fallout.
The selloff at the end of February infected all markets, including the European credit markets which saw high volumes of selling in the last few trading days of the month. Trading in the CLO market remained light and liquidity trended lower into the end of the month. This coupled with weak underlying loan and bond performance led to a general weakening in the performance of the strategy, offset partly by hedges we had layered on since late January.
Before the month end volatility, we managed to make a few relative value based trades, moving up in fundamental quality as well as building strategic stakes which we believe should outperform from a fundamental perspective through any potential stress to come.
Should the pandemic continue on this trajectory, we expect the immediate economic fallout to be large. That said, we also expect government (fiscal) and central bank support to come quickly and in substantial size over a sustained period. To the extent this does develop into a full-blown crisis, it would not have its origins in an overleveraged banking sector, high short-term rates or ballooning credit which often precede the end of the typical business cycle. Indeed, many of the tools that policymakers can use have been tried and tested.
An exogenous shock such as this in our view will pass in the short term, and in the meantime, we expect to see a large potential opportunity set being generated. Under such uncertainty and fear, we expect to see a potentially dramatic repricing of risk and some irrational behaviour.
Over time, and with careful fundamentally led analysis, large dislocations from intrinsic value will become evident that can ultimately be capitalised on from a trading perspective. High levels of mark-to-market volatility will be a given in the coming weeks which we will need to navigate with caution, with an eye towards recovery in due course.
Market sentiment in January was volatile and driven largely by headline risk rather than economic and corporate fundamentals.
Early January saw markets taken by surprise at the killing of Iran’s most powerful military commander, General Soleimani, by a US air strike in Iraq. Markets sold off across the board and oil prices spiked as investors contemplated the possibility of another destructive war in the Middle East, with implications for oil production as well as trade through the Strait of Hormuz. These fears appeared short lived, however. Although Iran responded with attacks of their own, these were seen largely as a face-saving exercise and the situation deescalated quickly, with Iran also being caught off guard domestically after accidently shooting down a passenger airliner.
The second rather more meaningful driver of risk sentiment to the downside in January was the outbreak and spread of a “novel” Coronavirus in China, bringing back memories of the SARS epidemic of 2002/03, but in a world where China is a much larger share of global GDP and had been recovering from last year’s damaging trade war with the US.
The headline-driven market moves through the month overshadowed persistently resilient economic fundamentals. Survey data in Europe came ahead of expectations in January, and the US and China signed their “Phase One” trade deal mid-month.
The Bank of England defied market expectations of rate cut as the economy showed tentative signs of a post-election “Boris bounce”, and in the US survey data was firmly in expansion territory, even in manufacturing. Furthermore, US GDP figures came in ahead of expectations, and somewhat weaker than expected hourly earnings figures eased fears of near-term inflationary pressure. Even with the Coronavirus increasingly likely to have a material impacts on Q1 growth in China, there appeared a growing consensus around Chinese government action to inject further stimulus to mitigate the economic fallout. January 31st saw the UK legally “leave” the European Union, although any effects are unlikely to be realized until the end of the transition period and the resultant UK/EU trade agreement.
In the CLO space it was a tale of two markets – while primary was quiet and only two new deals were priced with no reset or refinancing activity, secondary was very active. Activity via bid lists was high, dealers were active in providing two-way liquidity and supply was met with substantial demand. Both equity and mezzanine tranches were bid strongly, especially for higher quality paper which the Fund was well positioned for and had been trading into through the volatility of Q4 2019.
Weaker managers and profiles notably underperformed during the CLO rally, highlighting what we believe is the importance of our security selection, sourcing and trading abilities. We were extremely active from the very beginning of the year, with turnover of 15%, taking advantage of market technicals to move up in credit quality, tactically rotating the portfolio to take some profits and building strategic positioning.
The CLO market continues to play catch up with broader markets and the basis between CLO debt and Loans/HY bonds remains at wides, even accounting for the recent rally.
Fundamentals in the European credit markets remain strong – with trailing twelve-month default rates for EU leveraged credit only at 0.4%. The economic fallout from China’s Coronavirus remains to be seen, and we remain vigilant and ready to take advantage of any dislocations that may occur. Some assumptions in the market of the SARS playbook being repeated may well prove to be somewhat premature and misguided.
It is also very clear that more “tourist” players are now entering the CLO and broader structured product markets, increasing liquidity and the potential to extract further value through trading.
The general theme of increasing investor confidence and bullish sentiment worldwide continued in December, with markets staging an old-school rally into the end of the year.
Markets welcomed the avoidance of more tariffs and de-escalation in the US-China trade war as the 15th December deadline came and went, with both sides getting ever closer to a “Phase One” deal. While the trend towards the “decoupling” of the two world’s largest economies is not going away, near term headline risk has declined as we head into 2020. Furthermore, economic data continued to hold up, even in some of the manufacturing sectors that have greater sensitivity to trade war issues, with Chinese survey data still holding steady in expansion territory in December.
Monetary policy remains supportive globally and the fiscal stance of most economies relevant to our market is either shifting or has shifted to a growth favorable stance. Meaningful inflation in Europe and the UK is nowhere to be seen vindicating the ECB’s continued dovish monetary policy of low rates combined with ongoing QE. The Fed likely remains ‘on hold’ in the run up to the US Presidential election and in any case seems happy with inflation running somewhat above target for an extended period. US jobs growth remains strong even with record low unemployment, while the nagging question remains as to how and when this feeds through into higher wage inflation and so ultimately Fed policy. By contrast, the output gap in Europe remains relatively much larger and consequently has far more room before any monetary action is even contemplated.
In the UK, Boris Johnson pulled of a decisive victory in the UK’s general election, winning far more seats than expected, by capturing the traditional Labour vote in the Northern constituencies. This hands the Johnson Government significant power to steer Brexit policy without relying on different factions within Parliament and has avoided the tail risk of an anti-business, left-wing Labour Government under his opponents’ manifesto. Markets reacted strongly to this dissipation of political risk in the UK.
Risk-on sentiment continued to flow into European credit and by extension the CLO space, which has been lagging broader moves significantly.
Fund positioning was apt heading into December following the volatility in the CLO space since late Q3, where we had used the volatility to trade to the Fund’s advantage to reposition into lagging, mispriced and higher credit quality profiles. Indeed, trading volumes averaged 27% per month of Fund NAV over Q4 as we intensified this rotation.
Lower CLO supply with only two new issues and two re-issued deals provided a positive technical backdrop. The rally in the underlying loan market, coupled with a recovery in both fundamental and price terms across several “problem/stressed” credits, supported strong CLO Equity NAV appreciation and market value coverage ratios – all feeding through into stronger valuations for the strategy’s positions.
There was meaningful spread tightening over the course of the month and junior CLO debt performed very well. Despite the naturally quieter second half of December, we still managed to execute a number of interesting trades during the month across both secondary and primary markets, including selling into strength to crystallize price appreciation into the year’s end.
Overall, we are satisfied with performance through what was a very tough year for the CLO market relative to broader credit markets. Headline risk, whether credible or not, dominated the agenda throughout the year, combined with a deluge of primary issuance in certain months creating mispriced technicals that we were able to trade into. We believe we have managed this market backdrop appropriately and used a unique blend of structuring and trading expertise to extract value across both primary and secondary markets.
Looking forward into 2020, we expect continued improvement in the macro environment, supportive fiscal and monetary policies worldwide to facilitate the extension of the credit cycle. As this plays out, we expect more attention to be paid to the increasingly stretched valuations, room for maneuver and political risk in the US versus relative value and longer remaining runway in Europe. We expect the translation of this effect to continue feeding through into the European CLO and ABS markets as spreads remain far off their post-2008 tights. While we do not expect a rapid improvement in economic growth in Europe, we expect just enough to keep corporate balance sheets healthy and the low interest rate, low inflation environment with a sprinkling of QE to remain supportive for credit fundamentals. The relative value proposition between CLO debt and corporate credit remains very large, and we expect ever more market participants to take notice of this as the “hunt for yield” resumes. With bouts of volatility still expected during 2020 and simple relative value attracting ‘tourists’ to our space, we anticipate trading opportunities to remain plentiful.
November showed further signs of a bottoming out in economic performance worldwide as Germany and the UK avoided a contraction, and US GDP outperformed expectations of a slowdown to show acceleration quarter-on-quarter.
The service and consumer sectors, which make up the majority of most developed economies, remained very resilient and continued to avoid spillover effects from the manufacturing and industrial sectors. Further optimism fueled broader financial markets as the US and China reached an “in principle” agreement for the rolling back of tariffs upon the signing of a “phase one” trade deal. While there is no doubt that there are more steps likely in this process, and deeper geopolitical and strategic issues to untangle between the world’s two largest economies, optimism over trade continued to drive increasingly positive market sentiment. This led to strong gains in equity markets and year-to-date lows in volatility indices just before the end of the month.
The UK’s “Brexit” dominated general election heated up, with Sterling volatility increasing as opinion polls narrowed – although still indicating a Conservative majority and therefore clarity on the direction of Brexit, further reinforcing positive market sentiment across both Europe and globally.
Credit and equity markets both performed well as the month progressed, with material tightening towards the end of the month in European corporate credit (XOVER -12bps, MAIN -2.5bps).
The CLO primary market slowed in November, with new issuance of EUR2.8bn down from EUR4bn in the previous month. Liquidity in the secondary market picked up after the CLO market’s torrid “Red October”, with fewer primary deals in the market adding a technical tailwind to spread movements coupled with an improving macroeconomic picture. CLO equity NAVs had a strong month in November as leveraged and HY credit rallied across the board.
The credit curve flattened with mezzanine debt spreads beginning to tighten from last month’s wides and higher quality equity reversing some of the October mark-to-market losses (although still lagging significantly the moves seen in mezzanine tranches).
The wider relative value consideration in favor of European CLOs following the previous months’ dislocation has started to garner more investor attention and we expect strong performance through year-end in our asset class, especially as headline risk diminishes and underlying collateral pools continue to both rally and perform fundamentally.
Anticipating these moves we used the volatility in our market to add further convexity to the Fund in lower mezzanine tranches, as well as rotating up in quality in CLO equity where conditions in the secondary market were conducive to trading.
Furthermore, we leveraged our close market relationships and structuring capability to add positioning in some unique shorter dated primary junior mezzanine CLO paper with high scarcity value, as well as increasing diversity through positioning in European ABS sectors offering stability of return.
We believe the strategy is well positioned to take advantage of the increasingly positive technical tailwinds In European credit as headline risks dissipate and QE restarts in earnest, benefitting from continuing strong performance in European credit at a fundamental level.
Broader markets in October highlighted the mood swings that have been characteristic of 2019, especially when compared to the risk aversion that was prevalent during Spring and Summer. Stock markets hit record highs in October on increasing signs of progress being made on a US-China trade deal, a Fed rate cut later in the month and resilient economic numbers. In particular, strong employment and GDP data surprised to the upside.
China’s growth slowed to a 27-year low, affected by both the trade war and a natural tailing off in trend growth (somewhat expected of an economy at this stage of development). That said, China’s growth remains substantial in relative global terms. Long-end rates worldwide sold off significantly in a very short space of time, reflecting the risk-on mood of the month.
At the end of the month the UK parliament finally found something to agree on: the holding a snap general election in early December; the Conservative party are current favourites to win a majority with which to push through their proposed Brexit deal. This came after PM was forced to submit another Article 50 extension request, removing the risk of a very near term “hard Brexit”.
Overall, from a macro standpoint it feels we have come a long way from what the rates market was telling us earlier in the year, e.g. headlines around yield curve inversion and imminent recession.
The European CLO market saw a significant re-pricing in October on the back of continued heavy primary supply and contagion from the weakness in the US CLO market weighing on sentiment. Activity lower down the capital structure became noticeably weaker, with BBs and Bs getting harder to place and widening fairly dramatically in spread terms, even as senior tranches for tier one managers in Europe hit YTD tights.
This weakness naturally fed through into the secondary market, with secondary CLO equity seeing very thin liquidity with many auction bid lists either failing to meet reserve prices or, to the extent trading occurred, at multi-year wide risk-adjusted yields. Bid/offer spreads widened materially as a consequence.
Our view is that the weakness in the European CLO market is primarily technically driven. The fundamental outlook continues to remain resilient, with CLO equity distributions outperforming expectations across our holdings.
The dislocation in the CLO market is really at odds with the broader macroeconomic environment, which is showing signs of bottoming data and positive trends given accommodative policy worldwide, low defaults and progress being made on geopolitical/trade disputes. As a result, we now see significant value in specific segments of the CLO market in Europe (e.g. sub-IG), with technicals having largely decoupled with the broader macro markets.
European CLO debt spreads are now at levels seen at the start of 2016, where a similar technical sell-off led by weakness in the US which ultimately reversed, leading to opportunity for outperformance.
September saw the further development of two key macro themes – the realisation of expected Central Bank stimulus globally, together with a raft of ongoing and emerging political events. The Fed followed through on a further rate cut, continuing to cite spillover effects from the slowdown in the global economy, and was forced to intervene in the short-term funding markets which saw high volatility.
Mario Draghi used his penultimate ECB meeting to unveil a programme of monetary policy measures – most significant for us was the restarting of QE to continue potentially indefinitely. The programme also included a further 10bps cut in the depo rate and a system of tiered rates designed to relieve some of the pressure on banks’ profitability. We believe these measures to be very supportive for corporate credit risk at a fundamental level (indeed there is expected to be a component of corporate purchases embedded in the QE programme), and this plays well into the
strategic positioning of the strategy.
Additionally, Draghi was more explicit in his rhetoric around the need for perennially stubborn Governments in Europe to pick up the mantle on fiscal spending. Both as a means of increasing the effectiveness of the ECB’s monetary policy, but also with the underlying implication of monetary policy having reached its outer limits in terms of magnitude. This is especially the case now, given Governments across the Eurozone are effectively being paid to borrow!
In addition to the Fed and ECB, China’s PBOC also introduced more monetary easing measures through lowering reserve ratio requirements and rate cuts to bolster their own slowing economy and the negative effects of US trade tariffs.
Political risk shot up in the US as opposition leaders in the House of Representatives opened up an impeachment inquiry into Donald Trump that looks to be gaining some traction. The UK/EU Brexit talks continued to stall with toughening rhetoric, a possible general election and the “Exit Date” getting ever closer. In Hong Kong, protests continued with escalating violence; how Beijing eventually reacts to the situation, given historical precedent, remains a cause for market concern.
September was a busy month for the strategy with 14% turnover and the realisation of a couple of event driven situations, as well as tactical relative value trading in both CLO mezzanine and the ABS space. We also took advantage of some attractive opportunities in a somewhat dislocated primary market, in what was a reasonably active month for primary, split roughly equally between new issue and refi/reset paper.
Overall, we continue to see value in the fundamental and technical performance of the European credit market, with defaults remaining low and policy now even more supportive (above). On a relative basis CLOs remain very cheap versus broader European credit. In addition, the ongoing tightening in AAA and IG spreads increases event driven optionality (e.g. through restructuring and refinancing type situations), which we expect to be accretive to overall performance.
While idiosyncratic risks in European credit have been rising somewhat over the course of the year, albeit not to the level observed in the US market, we look to take great care to manage these as well as looking to take advantage of the opportunities that will no doubt arise.
Somewhat of a Brexit denouement also looms large in the coming months, which may also provide ample trading opportunities. Furthermore, European CLO portfolio managers have been taking great care to minimise the risk of any Brexit disruption, with few Sterling exposed issuers.
August turned out to be a very volatile month against a backdrop of large macro moves and lighter trading volumes across markets. Yield curves globally saw inversions – often seen as a harbinger of recession – and markets sold off as a consequence. The US-China trade war rumbled on and a new UK Prime Minister heightened his rhetoric to take the country out of the EU without Withdrawal or Trade Agreements in place. This increased concerns around the potential for severe disruption to the UK, heaping pressure on Sterling. Inflation and manufacturing data in Europe continued to disappoint but the bright spots in the services and consumer sectors remained. Below target inflation and a somewhat progressively weaker economic outlook primed the ECB for a large stimulus package at their next meeting, with interest rates diving ever lower. Even Italian BTPs fell below a 1% yield level by the end of the month as Lega’s snap election gamble backfired, with M5S agreeing to try and form a coalition with pro-EU PD, leaving Matteo Salvini’s party out of government.
Trading volumes for the fund were lighter in August, but nevertheless we managed to execute on an event driven situation from which we expect the Fund to reap future rewards. In addition, we used the volatility to execute on some relative value driven rotations in both equity and mezzanine, adding quality exposure which had traded down on August technicals and where we retained fundamental conviction. While CLO spreads for mezzanine and equity paper widened over the course of the month, Fund positioning still resulted in a flat performance trajectory – which we see as acceptable in context of the wild macro swings that occurred throughout August. When looking at markets from a relative value perspective, CLOs look like extremely good value. For example, BB-rated CLO mezzanine bonds are trading at a 400 basis points premium to similarly rated corporate debt (which do not benefit from the credit enhancement, structural protections and diversification that CLOs offer). Furthermore, continued tightening in CLO AAA spreads has increased the option value to equity embedded in CLO structures and may continue to trend favourably. Broadly, fundamentals remain strong in the European loan market with defaults staying low and many of the more “tail” credits posting positive and improving financial results. Moreover, we expect Central Bank dovishness in the coming months to add both fundamental and technical tailwinds to our asset class.
Monetary policy reached a key inflection point in July. The Federal Reserve made its first interest rate cut since 2008, potentially starting a new cycle of easing. Industrial production and manufacturing data worldwide continued to disappoint led by the US-China trade war, as well facing headwinds from tensions between Japan and South Korea and the shortening Brexit timeline. The “mid-cycle adjustment” comment made by Chairman Powell was an interesting point of comparison and debate compared to previous blanket market assumptions of late cycle behaviour. Inflation remains low worldwide, with CPI data in Europe continuing to decline even with unemployment either generally stable or falling (across the continent). In July’s ECB Meeting, President Draghi spoke of an economic outlook which was “getting worse and worse” and prepared the Eurozone for further monetary policy action at the ECB next meeting. Global rates continued to decline, with more than USD 13 Trillion of debt worldwide trading at sub-zero yields. This combination is expected to push market participants down the credit curve and add a positive tailwind to European credit markets.
CLO spreads in July generally moved sideways to wider. The European market saw the most active month of new issuance since the inception of the European 2.0 CLO market (EUR 5.4bn for July) – albeit with very little refinancing and reset activity. Trading in the month focused on managing net duration exposure and using market conditions to add both convexity and credit quality. Looser counter-cyclical monetary policy worldwide in the face of geopolitical tensions and slowing growth should push investors to reach further for yield and increasingly drive them towards assets such as CLOs which trade at a material spread premium to similarly rated corporate or sovereign bonds. Furthermore, Euribor rates already below zero and falling increase the Euribor floor benefit for CLO investors the further one goes up the capital structure, enhancing this relative value consideration even more. We expect the political and geopolitical situation globally to remain volatile with ongoing trade issues, Brexit eventually coming to a head and the risk of new elections across Europe to name a few! With underlying fundamentals in the European loan/CLO market remaining intact and a backdrop of favorable monetary policy, this environment portends a very interesting opportunity set from a trading perspective.
Central Banks worldwide doubled down on their dovish stances in June faced with a picture of weaker growth, disinflation and widespread uncertainty, especially around manufacturing and trade. The Federal Reserve argued at their June meeting that “the case for rate cuts” had increased, a sentiment which the rates market has more than agreed with for some time. Market expectations are for multiple rate cuts from the Federal Reserve over the course of 2019 and 2020. In Europe, outgoing ECB President Mario Draghi also indicated the ECB’s readiness to reduce interest rates even further below zero in order to revive falling inflation and economic growth expectations. These actions together spurred a large rally in global rates, with something around $13 trillion of debt worldwide now earning a negative yield as a result. Overall, one could argue the recent hawkishness of the US Administration on trade has been largely offset by the renewed dovishness of global central banks. Equity and credit markets also benefitted from the dovish rhetoric and the more positive tone in the lead up the G20 meeting at the end of the month. The market backdrop continued to improve as Presidents Donald Trump and Xi Jinping agreed to call a truce on trade war tensions and reopen face-to-face trade talks, though the widespread view in markets is one of caution on this topic.
The collapse in global bond yields worldwide should lead to a resumption in the “search for yield,” which we expect to eventually feed through into the structured credit markets, where CLO debt continues to earn a significant premium over similarly rated corporate credit (both IG and HY/Loans). Continued dovishness by central banks worldwide for the foreseeable future should also keep corporate default rates low. Indeed, we expect the extension of the “lower for longer” mantra at the ECB and a likely resumption in QE in the short-term (“QE II”) lends further support to both fundamentals and asset prices in the European credit space. The observed sideways trend in CLO credit spreads is reflective of the somewhat elevated primary market supply in both EUR and US CLO markets. While CLO issuance in Europe is running at +15% higher YTD versus the same point in 2018 (around a EUR 2.5-3bn run rate per month), we expect the primary supply overhang to dissipate in the near term, leading to a more constructive technical dynamic. Given both this and underlying credit fundamentals remaining intact under a net more dovish backdrop, we see a lot of room for upside going forwards from current positioning. The inevitable trade, economic and political noise will no doubt generate incremental trading opportunities over the quieter Summer months.
Hopes of a swift resolution to the US-China trade dispute were dashed in May as talks broke down and further increases in tariffs were enacted, with promises of more to come. As a result, markets were on the back foot, with major equity indices under pressure and credit bleeding wider. The ongoing trade war and related uncertainty continued to dampen industrial production indices worldwide, with many manufacturing PMIs in contraction territory. Despite this the service sector in developed markets continues to hold up well and unemployment remains low. Furthermore, inflation remains stubbornly low, supporting a dovish stance by central banks worldwide. Right at the end of the month President Trump injected a further shot of fear into the markets by linking trade tariffs to a separate political issue – namely immigration. The threat of a ratcheting schedule of tariff increases on Mexico in order to bring them to the table on border controls led the market to extrapolate a variety of new scenarios and ushered in a further bout of market volatility.
The strategy avoided May’s volatile broader market re-pricing, a testament to the relatively uncorrelated nature of our portfolio and asset class. Despite XOVER widening ~60bps, both the term structure and credit curve for European CLO paper flattened with strong demand for primary deals pushing junior debt spreads tighter at the long end (despite reasonable levels of supply which brought YTD EUR CLO 2.0 issuance to ~EUR12bn). This especially benefitted the longer dated portion of the book, and most positions saw spread tightening. We added some high-quality equity profiles as well as bolstering the short-duration proportion of the portfolio. In addition, we tactically added some longer-duration junior mezzanine positions, which we expect to perform well in the coming months and took profits on some of our shorter-term tactical positions. We stand ready to react to further bouts of volatility thrown up by ongoing trade disputes and political uncertainty.
Optimism was high in April as US-China trade talks appeared to be moving towards a resolution and economic data remained strong in the US with significant beats on GDP and employment. The S&P 500 topped its all-time high late in the month on the back of strong corporate earnings, and volatility hit YTD lows.
Broader markets worldwide have now recovered the majority of their losses from the end of last year. The European service sector survey data beat expectations and manufacturing showed signs of bottoming. Employment data across the Eurozone showed job growth and GDP showed a slight improvement.
The European credit markets performed well, with the ELLI up +0.72%. The CLO secondary market finally started to participate in the market recovery in April with spread tightening across the capital structure – a welcome development given the positive macro picture in Q1. Furthermore, there was visible demand for CLO equity which helped push through price appreciation in conjunction with the recovery in underlying NAVs at the loan collateral level.
That said, on a relative basis when compared to other ABS/structured credit asset classes, European CLO spreads still remain wider when compared to end Q3 2018 levels. The strategy benefited from these dynamics as well as very strong equity distributions from some of our strategic positions, in several cases these being at the higher end of our expectations.
“To improve is to change, so to be perfect is to have to change often”, said Winston Churchill. He may not have been referring to structured credit portfolio construction, but if there is one defining characteristic that marks our efforts in the first quarter of 2019, it is taking advantage of the spread widening to 2017 levels combined with lagging recovery versus broader markets in our asset class. This provided an attractive entry point for trading into better credit quality assets. We added more shorter duration CLO mezzanine bonds, with strong convexity that we anticipate will perform well as the CLO market catches up with the broader rally. The lower duration allows us to have lower beta when faced with more bouts of volatility as the cycle continues, and thus providing what we see as lower correlated, risk adjusted returns with a large margin of safety. This was our thesis at the beginning of the year, and we are pleased with the execution of this strategy.
We see these positive effects in our attribution analysis.
Compared with broad equity indices, such as the Eurostoxx 600, which rallied +15.0% over the last quarter (having dropped c11.5% in the previous one), the Q1 may seem muted. However, we are focused on alpha generation and downside protection in a risk-adjusted context. We think that the performance speaks to the less correlated nature of our strategy when investing in this asset class. As the macro picture becomes more certain and real money buyers come off the side-lines and back into our market, we hold our thesis that we will see price appreciation in our current portfolio.
Diving deeper into the macro picture, we saw that in Europe, markets grappled with some negative economic news. Germany and Italy underperformed. The Brexit uncertainty continued. US-China trade uncertainty and the second order effects of slowing Chinese growth fed through into the industrial sector. Despite weak numbers in manufacturing, the service sector held up throughout Western Europe, which is the dominant sector in most developed European economies. Inflation slowed but the ECB reiterated their forward guidance and announced a new round of TLTRO to help the banking sector. Trailing twelve-month default rates in the European loan markets are at approximately 0%, and while growth has slowed the ECB remains highly supportive and we do not see a near-term European-wide recession. We maintain our view that this environment is highly supportive of credit from a fundamental perspective. There are several emerging markets such as Argentina, Turkey and Venezuela suffering various degrees of economic crisis, but we see no real risk of contagion here.
The Brexit can was kicked down the road as the UK Parliament found it difficult to make up its mind over exactly how it wants to leave the European Union. An extension was agreed, but we do not yet see opportunity in the Sterling markets, having sold our UK risk exposure around the time of the referendum. Looking at the UK domiciled corporates that some of our positions have look-through exposure to, we see minimal impacts from a disruptive Brexit scenario from a fundamental perspective. However, we may look to further hedging if the situation deteriorates given the potential for higher mark to market volatility.
In terms of geography, we maintain the view that European CLOs offer best potential value for structured credit investing across markets (including the US). Fundamentally we think that credit quality in the US is much lower in CLO portfolios, with higher default rate risk, CCC buckets, lower weighted average spreads and loan prices. Further up the corporate capital structure we see a higher proportion of lower rated credits in the US relative to Europe and, as a result, higher downgrade risk residing within CLO portfolios. While headline leverage (Debt/EBITDA) is comparable in European credit, this hides the effect of far more aggressive “add-backs” and other accounting techniques in the US, as well as looser lending and documentation standards more broadly. Furthermore, even though it has been stretched as of late in both markets, the European CLO equity arbitrage remains more attractive on a relative value basis over the US CLO market.
Lastly, new issue CLO equity arbitrage is relatively stretched as a result of relatively tighter loan markets and wider CLO liability spreads – meaning that many of our older vintage, higher quality CLO equity positions should benefit from scarcity value as they were issued when the weighted average debt cost was much tighter and documentation somewhat more flexible for equity investors. To obtain favorable debt financing, CLO equity investors in this market may have to make concessions on covenants and accept tighter documentation and reinvestment language, while for many of the existing positions this healthy tension was resolved with more flexibility in favor of the provider of equity capital.
Looking forward into the next quarter, with a sustained recovery in broader credit markets, we believe our positioning has the potential to deliver strong risk adjusted returns. On the 25th anniversary of his untimely passing, we remember the words of the legendary Brazilian Formula One racing driver, Ayrton Senna, who once said: “I have no idols. I admire work, dedication and competence”. We also greatly admire these qualities and will continue to strive for these in our quest to outperform.
2019 February summary
In February we saw a continuation of stronger markets, which continued to rally across the board in fixed income and equities, through improved sentiment around China-US trade talks, Fed dovishness and US economic conditions. We highlighted before these as key risks for markets, and it is perfectly normal that a path towards a positive outcome has to be met with a jolt in market sentiment. Going forward, we are focused on what other clouds could emerge and continue to believe that it is very possible for the Fed to move in a different direction if the macroeconomic data warrants it, or for President Trump to focus his ire on the EU as the next in line.
Economic data in Europe showed continued weakness in Italy and Germany. Within this, however, we note the greater impact remains on the manufacturing sector while services continue to remain solid throughout the Eurozone.
Over the course of the month, expectations have also been building around the ECB taking action, with TLTRO (long term financing to banks) being mooted, though this not being necessarily obvious.
In the UK, Brexit continued to cause headaches and chaos without a clear outcome. Pragmatism started to emerge outside the political arena but any financial and economic disruption that may result from Brexit is yet to be quantified given the uncertainty around what flavor of Brexit we finally get. We continue to screen the market for interesting directional UK risk, but at present we do not perceive we are being sufficiently remunerated for adding risk at current levels given the outlook of an uncertain and short-term binary outcome.
This month should be seen in the context of the CLO market missing out on the rally in virtually all broader markets – European CLOs in particular stand out as continuing to lag this generalized recovery.
As we look forward to Spring and the start of the new Formula One season, there still remain several clouds on the horizon, though we do believe there are signs of potential upside which are building. The many issues which have weighed on sentiment look like they may be either close to a resolution in the coming months, or with a pathway emerging to a resolution, e.g. progress on the US/China trade dispute, growth worries becoming more specific and clearer, emerging clarity expected on Brexit, etc. Furthermore, we expect central banks to remain supportive of financial markets, particularly in Europe where are large part of the fixed income market, particularly shorter duration, remains in negative rate territory. Indeed, we expect the ‘lower for longer’ mantra to remain intact for some considerable time to come. We continue to be vigilant and ready to change our stance, while remaining constructive on our current portfolio profile.
2019 January summary
Risk markets rebounded from their lows after a volatile Q4 2018 as fears over central bank policy, global growth and ongoing trade disputes faded somewhat. It appears that the sell-off had gone too far in the eyes of market participants and that recession risk in the US may not have been as high as implied by December’s market pricing. There were some signs of life in the US-China trade talks, with China pledging to buy a “substantial amount” of good and services from the US. However, this only addresses one of the issues (the trade deficit) and does not address other concerns such intellectual property and ownership structures – so there is still a long way to go. A new Congress was sworn in at the start of the month, with split chambers – so we would expect at the very least gridlock on US domestic policy and the potential for a less business and market friendly environment from a political standpoint. That said, historically speaking, gridlock has been seen to be generally positive from a market performance standpoint.
The key event of the month was the release of Federal Reserve minutes, presenting a partial U-turn on monetary policy in the US – with the Fed insisting it will be “patient” with adjustments to monetary policy, taking account of the tightening of financial conditions that occurred in Q4 last year. Very strong jobs numbers, continued investment in technology, and rising labor force participation (i.e. more people coming back into the workforce) coupled with no sign of meaningful inflation all imply that there may yet still be some slack in the American economy. This coupled with a reluctant Fed has the potential to extend the economic cycle, barring major exogenous shocks.
In Europe, Italy was a notable underperformer, slipping into technical recession in Q4. While this was not particularly unexpected from our standpoint, the Fund has minimal exposure to Italy and those companies that do issue debt are generally in defensive sectors such as Telecommunications. Other countries have been showing signs of slowdown, but we believe there is no clear catalyst for a European wide recession in the short to medium term. One expects credit defaults to slowly drift upwards - but from a very low base and not materially. Furthermore, this allows monetary policy to remain loose, which is positive for credit markets – lower growth prospects are more of an equity story. Any market response to this is likely to be technical in nature, which throws up trading opportunities for the Fund and may tighten underwriting standards for those companies that need to access the capital markets, incrementally raising credit standards over time.
There were key developments with respect to Brexit in January, with Theresa May finally putting her withdrawal agreement to parliament after postponing the vote from December. The result was resounding rejection of her deal, primarily because of the Irish “backstop” – an insurance policy designed to keep the UK in the customs union with the EU in the event of a breakdown in trade talks, which has proved to be politically toxic. This was the largest parliamentary defeat for a British government in modern political history. The PM has signaled that she will return to Brussels to try to persuade the EU to drop the backstop – which looks highly unlikely. A crunch point is coming for the UK as the clock ticks down – but ultimately “no deal” is in few people’s interests. Ultimately a compromise is likely to be reached, but the path to this outcome may throw up some surprises which we hope to capitalize on.
Trading volume was high in January: 29%, with trades of both a tactical and a strategic longer-term nature being executed. Mispriced and lagging markets offered up multiple trading opportunities, with some positions being bought and sold for profit intra-month. We increased the core positioning of higher credit quality assets, taking advantage of the dislocated market conditions where fewer participants were trading.
The primary CLO market reopened tentatively in January, with only one transaction pricing. There are several CLOs in the pipeline, but it is clear that primary deals are going to be harder to execute with tight liability structures in Q1 2019. Some of the strategy’s equity positions should perform very well in this environment as the relative cost of funding versus new issue is considerably lower and cannot be replicated in today’s market, on top of benefits from heightened loan/HY spread volatility.
While we have minimal exposure to Italy and the periphery more broadly, we are keeping a close eye on growth in Europe. Europe’s economic outlook is mixed with pockets of both underperformance and outperformance. This coupled with low Eurozone wide inflation means that monetary policy is expected to remain loose and accommodative for the foreseeable future. As a result of this we see no catalyst for any significant increase in defaults and remain confident that the Fund is well positioned to benefit from the financial market volatility that the upcoming months are likely to throw up.
In addition, S29 ITRX MAIN and S29 ITRX XOVER widened +5bps and +16bps respectively. The US credit markets were more insulated, with the main CDS indices flat on the month and the cash indices posting marginal gains in total return terms (US HY: +0.4%; US LLI: +0.1%).
June was a busy month in European CLO primary, with seven new deals coming to market for a total of EUR 2.9bn. Primary AAA spread levels across the stack ranged from 79-87bps, with wider prints happening towards the latter half of the month. Two refinancings and two re-issues also came to market in a heavy month for CLO supply. The risk-off sentiment combined with a heavy primary supply technical led to a weakening secondary market in CLO mezzanine paper in Europe, with BBBs, BBs and Bs widening by +10bps, +15bps and +25bps respectively as the credit curve steepened, further compounding the steepening observed in May. Weakness in the underlying loan
collateral prices, driven by both market sentiment and supply, caused equity NAVs to decline. However, demand for CLO equity in deals managed by top tier managers with potential to take advantage of this volatility was strong on bid lists, especially for paper with relatively tighter liabilities. Increasing loan issuance supply (as a result of increased M&A activity) and spread volatility is beneficial for the arbitrage to CLO equity, which at the start of the year was being squeezed by a tightening loan and HY market. This also gives lenders more scope to push back on debtor friendly documentation (at the loan level) and takes some pressure off some of the collateral quality tests built into the CLO structure. The weakness in secondary was also felt in the US, where BBB, BB and B were wider by +5bps, +28bps and +30bps respectively.
At the beginning of the June the annual Global ABS conference was held in Barcelona, with the highest attendance since the financial crisis. Despite discussions around the risks of a trade war and the effects of the ECB’s unwind of QE, the mood was generally positive on the structured finance asset class. Attendees were very constructive on the CLO product and its risk-return profile, and there was also a focus on opportunities in periphery NPL supply as Europe continues its economic recovery. Over in the US regulators unveiled proposals to roll back elements of the Volcker Rule, which currently restricts US CLO managers from buying bonds (as collateral in CLOs).
In the face of continuing difficult market conditions, the strategy returned +0.6% in June. Following on from the high trading volumes in May, the repositioning of the fund into “up in quality” mezzanine profiles provided some insulation against the broad-based widening seen across the CLO mezzanine space. The Fund’s high quality, strategic equity profiles also provided an offset via price appreciation given heightened demand for certain profiles. Trading activity remained high as we took advantage of primary supply technicals and rotated into paper which we believe was mispriced from its fundamentals. Finally, we added further diversity in the form of vintage 1.0 ABS exposure with strong return potential sourced from a legacy account.