The CLO market is seeing record supply and spreads are racing back to pre-Covid levels, though the pandemic is still heavily affecting investor appetite and pricing, with older portfolios coming at wider levels. But some buyers are cautiously welcoming portfolios with complex credits, such as airlines.
Investors, sources said, have been increasingly focused on looking at clean portfolios with underlying collateral not linked to Covid-hit sectors, and avoiding situations with potential credit deterioration. But not all are so cautious, and there’s a price for every risk.
In partial refinancings, from triple-A to single-A — particularly in deals that are post-reinvestment — there are some CLO debt investors who are willing to accept more Covid names and CCC names, especially if the senior tranches in these deals are being repaid, explained a CLO market source.
But the overall tendency in a market overwhelmed by new issue deals, refis and resets is that, "cleaner portfolios from tier one CLO managers are achieving the best execution," said the same source.
The source added that this was especially the case "when compared to certain CLO resets which may have experienced par losses, have more Covid-19 exposure, and non-standard structural tweaks, such as split-rated tranches (senior BBB/junior BBB), multiple fixed-rate tranches, and adding in a large 'X' note and single-B tranche, to avoid a large equity infusion."
Apollo subsidiary Redding Ridge reset its 2017 CLO — named RR 2 CLO — on March 12, and it increased the deal by $300m to add high quality assets and meet the debt investor demand in search of a cleaner portfolio, according to a person familiar with the deal.
The $800m CLO, arranged by Bank of America, saw the extra-large triple-A tranche of $500m sold at 106bp over three month Libor, versus the original tranche of $277m senior notes sold at 118bp in 2017.
The metrics to examine the cleanliness of a portfolio are multiple and likely vary between investors.
For Andrew Ross, senior director and head of investment risk management at Pacific Asset Management, it is not just a function of the level of triple-C rated loans in a deal, the underlying collateral sectors sensitive to Covid or spread dispersion, but a major component is "the market value of the underlying collateral".
"What we are seeing now, with many of the resets coming, is that the market value coverage for the mezz tranches is lower than it would be for a brand-new clean portfolio," Ross said. "The market is just pricing that in. With the new reset onset, investors are adjusting their pricing to account for the portfolio and if the portfolio is inherently weaker than it would be if it were a brand-new issue, then it is being priced accordingly."
Company not sector
The surfeit of supply has started to weigh on spreads, softening pricing across mezzanine tranches and recently putting pressure on triple-A spreads after a three month rally.
For Roberta Goss, co-head of the loan team and CLO platform at Pretium Partners, the recent volatility in spread levels "is a function of the differentiation between new issue 'clean' portfolios and reset/refinancing activity with 'seasoned' portfolios".
She added: "In recent weeks the market has begun to increase the cost of reset transactions and as a result we have started to see a shift to refinancing deals, and in some cases just the senior tranches."
When examining portfolios, CLO investors remain cautious on more vulnerable industries in the economic recovery, but there is also a view that certain Covid names are not necessarily bad or that specific companies, within hit sectors, can be in a better or worse shape.
"The recent AAdvantage transaction from American Airlines [a loyalty programme-backed loan] has proven to be attractive and was met with strong demand," Goss pointed out. "It follows the two loyalty deals that came to market in Q3 of 2020 from United and Delta. There is broad-based agreement that the collateral backing these transactions is valuable and the economics and structure of the loan provides good outright value."
The manager also noted that ESG-sensitive industries are underperforming and, "mining and more recently coal-powered utilities have been under pressure with recent statements from the administration."
Goss's projections are that for those industries this underperformance has accelerated in the past year and, "I would expect it to become even more expensive for companies in these industries to issue going forward."
Rating agencies are still focused on analysing the credit quality of Covid-hit sectors, following a year with record downgrades and defaults in leveraged loans.
Industries such as hotel, gaming and leisure, consumer goods and services, oil and gas, and retail are expected to remain under pressure in the short term, according to a mid-February report released by DBRS Morningstar, with a "more meaningful recovery in demand for personal services, particularly travel and hospitality, to begin by Q3".