European opportunities and the future of CLOs — Q&A with Palmer Square CEO Chris Long
Kansas-based Palmer Square Capital Management has been one of the most active managers of the year, particularly in the pandemic era, with six CLOs priced in 2020. The firm, which manages $12.3bn in assets as of July 31, has specialised in static CLO issuance, and during the crisis was able to price three static deals in the US, as well as one in Europe. Chairman and CEO Chris Long spoke with GlobalCapital about the future of CLO market, the advantages of static deals in times of crisis and opportunities in Europe.
CLO deal structures have adapted to the Covid crisis, with shorter periods and static formats. Are we entering a new era for CLOs?
In the very near term, we believe yes. However, as we get back to more normal post-Covid spread levels (e.g. AAAs in the 120-140bps range), we would anticipate a shift back to longer reinvestment and non-call periods. Four-year reinvestment with a two-year non-call period is probably the next step, but we believe getting back to a five-year reinvest with two-year non-call within the medium term is a logical landing point for the market. As to Palmer Square, we will continue to opportunistically pursue a mix of static and reinvestment deals similar to how we have done in the past.
Palmer Square Capital Management is the largest manager of static CLOs. What is the attraction of this structure during periods of volatility?
Given the lower cost of liabilities advantage, we have been able to ramp very high-quality portfolios without sacrificing equity returns. In volatile times, our high-quality research bias has greatly benefited out portfolios. For example, the average PSTAT WARF is 2951, which is almost 300pts below the market median. Our PSTAT portfolio has also had a much smaller portion of its constituents downgraded to CCC: 4.94% vs 8.80% market median. Last, defaulted balances in PSTAT portfolios are only 0.26% vs 1.90% for the market. Most importantly, our equity cash flows continue to be incredibly strong and our minimum OC ratios are averaging 5 points of cushion (hence, like our reinvestment CLO platform, we haven’t had issues during volatile periods).
On the issuance side, we believe that our strong performance history has allowed us to bring static deals at very opportune times, such as PSTAT 2020-3 in May 2020. Even though the cost of liabilities was slightly wider, relative to our previous PSTAT deals, the cost of assets was even lower, equating to a very attractive equity arbitrage.
Your firm has been one of the most prolific CLO managers in the crisis, pricing new static and shorter CLOs. What have been the main challenges in bringing these deals to market, and with their different structures?
We haven’t faced real challenges, but instead having two tools in the toolkit has allowed us to get to market more quickly. We continue to strive to be nimble and methodically look to pivot between our different platforms to ensure we maximise the opportunity given to us by the market. On the portfolio management side, our investment process is the same regardless of the structure being static or managed so again we don’t believe we have faced challenges.
In either structure, we have frequently been re-underwriting our credits with new assumptions to account for us all being challenged by a post-Covid world. Ultimately, we believe this discipline and leveraging a well-worn investment process had led to fewer downgrades and defaults in our portfolios.
What are the hurdles CLOs have faced during this crisis?
In general, we believe CLOs are on track to survive another test, despite what the many naysayers believed would occur coming out of Covid. Overall structures have been very resilient and have worked as intended, especially in light of the challenging macro backdrop. For example, structures came under tremendous pressure in April and May as more than 30% of the loan market was downgraded by the rating agencies. With that severe a downgrade situation, at the end of June, about 21% of CLOs were failing an over-collateralisation (OC) test.
At this time, though, only about 15% are still failing an OC test, given the rally in loan prices. For this smaller portion of the market, it isn’t too surprising, given the positioning of those deals ahead of the market volatility.
Your firm opened an office in London, priced a static CLO in Europe and plans to price another. What opportunities does the European market offer?
Current liabilities spreads in Europe are tighter than the US, while loan prices are lower. This creates an attractive entry point, and we believe the equity arbitrage is compelling. With our higher quality research bias, we are also constructive on the European loan market as it consists of much lower-Covid disrupted sectors relative to the US market, interest cash flows are higher, and we project default rates to be lower.
In addition, until Palmer Square, the European CLO market has not had a committed static CLO manager enter the market.
Do you believe this period will attract more investors to CLOs, and what types would you expect to see?
Absolutely. Investors need yield — and so few pockets of relative value remain. In addition, from a risk standpoint, we believe this is just another market test and when we come out on the other side of this pandemic, investors will see that CLO structures held up very well once again (as during the global financial crisis and at so many other times dating back to 1993). As an example, we would anticipate more asset manager/typical bond funds will likely begin looking more closely at CLOs, given the lack of yield in traditional fixed income.
How do you expect the CLO market will cope with more defaults coming?
As expected, there will be more performance dispersion among managers. That said, CLO structures are built to withstand a very high number of defaults. We estimate it would take 8%-10% annual defaults for the life of a deal (eight to nine years) to just impair the BB tranche by $1 (i.e. receive $99 in principal rather than $100). Current defaults in CLOs stand at 1.9%. Even if all CCC-rated loans inside CLOs defaulted by the end of the year, that would get you to about a 10-11% default rate this year. You would then need to see that happen for multiple straight years to impair most BB tranches. We believe this is highly unlikely, especially if you have a higher quality bias to your portfolio.
Your firm is based in Kansas. Do you think that where managers are based is losing relevance and platforms might choose to situate themselves outside New York, as working from home persists?
I’m not sure it is losing relevance. However, we have found our Kansas-based location to be a significant competitive advantage from a recruiting, talent retention, and independence standpoint. The cost of living is also undoubtedly a benefit. It is possible, though, with this pandemic’s effect, that you could see more migration away from big cities such as New York.