Matthew Natcharian, managing director at Babson Capital Management, says collateralized loan obligations offered with original issue discounts are a key to attracting investors in the post-crisis primary market. Natcharian, one of the market’s most active buyers of CLO tranches, said recent deals are bolstered by stronger structures than older vintages, but that total returns in the primary market could use the OID lift.
“The new issue carries a very strong structure,” he said, noting the bonds’ newly issued high ratings and higher coupons. “But their total return prospects are somewhat limited in that we don’t expect them to eventually trade over par.” OID is when a bank prices a new bond below par.
Mezzanine tranches issued with OID were singled out as particularly appealing. “We think they are mainly attractive for buy and hold-type strategies, particularly for insurance companies.” Excerpts of the conversation with Managing Editor Joy Wiltermuth for Tranche Talk are detailed below. The complete interview can be accessed here.
The new issue pipeline largely consists of shorter-dated paper. How do you get comfortable with the shorter life of these bonds?
You should assume many of these deals will be refinanced and called by their equity investors as soon as the markets make it feasible for them to refinance at lower costs of capital.
How comfortable are you with the ability of CLO managers to find sufficient assets that work in short-dated deals?
I don’t think managers will be limited in their ability to select good credits. [But] they just will be more limited in replac[ing] those credits after the two-year reinvestment period, or in some cases, a one-year. That’s good for debt holders in that you have more certainty over what the composition of the portfolio is today. And, it’s unlikely to change materially over the next one to two years.
Is the availability of warehouse financing a concern vis-à-vis how this may impact CLO performance?
If you don’t have a warehouse, usually there is a model portfolio and you [need] a high level of confidence the manager will be able to create a portfolio similar to the model. In that situation, we would tend to focus on larger managers [who] have a strong ability to source new issue and a strong ability to trade in the secondary market. [They would also be] active traders and have good trading relationships, because that will be the key to them getting the portfolio at an attractive price.
Where are you finding opportunity in the secondary market?
Senior tranches on a fundamental risk adjusted basis are trading very cheap—in the low 200 spread range—for the first priority tranches. Although the absolute return is relatively low, it could be in the 2-4% range. That’s not attractive for a lot of investors even though it’s a very good return for the risk you are taking, which is relatively low. We are active in that part of the capital structure.
In the mezzanine tranches we are focused more for pension-type clients looking out two to three years. There we are buying things in the high-single digit yield-to-maturities out though five to seven year weighted-average lives. But we think over the next two to three years they will perform very well. We are buying those at a very significant discount to par.
What is your response to JPMorgan’s recent projections of $12.5 billion in new CLO issuance in 2011 and $25 billion in 2012?
One thing we are looking for is will banks, particularly banks and insurance companies, really be big buyers of the new issue first priority tranches. Some of the regulations that will be required around the capital you’ll need to hold for those have not been fully developed. We are hopeful those regulations get resolved relatively soon. A lot is riding on the regulations and market conditions in the first quarter.
Finally, are you eyeing opportunities in European CLOs?
The universe of deals we are willing to focus on there is a little bit smaller, but we do think there are some good opportunities. There is a little more uncertainty in the outlook for the economy over the next year in Europe given the sovereign debt issues. We are a little bit hesitant to jump in to European CLOs right at the moment, but we are looking at them very actively and do think on a select basis there will be some good opportunities to pick up some extra yield in that market over the U.S. CLO market.