4th Quarter 2020
CLO comment: Path towards normality
The European CLO market enters 2021 on strong footing. Both the market for CLOs and the investment vehicle itself has proved resilient to the heightened uncertainty and deteriorating economic environment. Overall, the asset-class has performed as expected, and we continue to see great value in the premium investors can earn on CLO notes compared to comparable rated corporate bonds.
The market has been well-functioning throughout most of the year, with 66 deals issued compared to last year’s record of 72 deals. There have been CLOs successfully brought to market in every month of 2020, and 5 new managers succeeded in issuing deals. CLOs issued in 2Q and partly 3Q had more conservative documentation to attract investors, but we view this adaptability as a positive element, underscoring both flexibility from CLO managers and investor demand.
Especially the fourth quarter was ‘business as usual’. 22 deals were issued, compared to 19 last year. Spreads tightened meaningfully, for example, AAA-rated notes tightened from close to 140 bps to 110 bps., supporting the economics for issuing further CLOs.
Looking to 2021, several CLO managers and investment banks have informed us of their plans to issue new CLOs in the first quarter of next year, and market analyst expect spreads to continue to tighten as the higher return on CLO notes continue to attract investor demand.
CLO Investment Grade Fund
We have kept the rating-composition unchanged during the final quarter of 2020. Here at year-end the fund is 70% exposed to BBB-rated notes and 30% exposed to A-rated notes. The expected return on the BBB-rated notes varies from 360-380 bps for shorter duration notes to 450 bps for the longer running notes. For the A-rated notes, the shorter duration notes yield around 275 bps and the longer running ones yield around 325 bps. In total, the expected return for the fund is [380 bps].
We have made a few changes in the portfolio, including a reduction in our Accunia 1X BBB-rated position and adding a new-issue BBB-rated note from Alcentra.
Credit metrics on the fund’s assets are generally flat to slightly positive on average for the quarter. The solvency test (“overcollateralisation test” or “OC test”), which is the primary determinant of whether cash flow should be diverted, has steadily improved in the second half of the year. This shows that CLO managers can build value in the portfolios.
The graph below shows the weighted average loan price among the fund’s assets. As can be seen, we are approaching the levels we saw in the start of the year. The average loan price is around 98.5%, and 75% of all of the fund’s assets have an average loan price above 98.1%. Looking at the rating-composition of the underlying loans, we are also seeing a slight improvement during the quarter.
Weighted Average Loan Price
It should be noted that particularly the rating composition has deteriorated from the start of the year. This is not a direct problem for CLOs, but it does reflect the negative economic impact of COVID-19. On the other hand, a lot of companies have used the positive market conditions to extend their debt maturities. As a result of this, 90% of all underlying loans have a duration of more than 3 years. This mitigates some of the initial default risk and gives companies some time to regain their footing.
If we analyse the resilience of the fund’s assets going into 2021, the protection that investors have is still more than adequate to compensate for the risk. The asset with the lowest OC test can still withstand 15% losses among the underlying loans. This is close to twice the amount of losses we saw in 2008 and 2009 combined (assuming 50% recovery rate, which is conservative).
As we saw in April, the lower liquidity on CLO notes expresses itself through larger mark-to-market swings compared to comparably rated corporate bonds. But 2020 also showed us that CLOs work as advertised – something we know in Accunia but see others doubt from time to time. The fund’s assets are far from notional losses, no coupons have been deferred, and we do not expect any to be. Combining these elements, the premium on CLO notes continue to be very attractive for the long-term investor.
Our plan going into 2021 is to continue with the current rating-composition, as this creates the most attractive risk/return profile to secure our dividend police going forward. Given the lower re-financing level in 2020, more than half of the fund’s asset can now be called. Given the CLO market’s current path towards normality, we expect more re-financings to happen in 2021. This will automatically generate additional return, as some of the fund’s asset trade below par. We will reinvest these proceeds across the curve, giving a balanced duration profile, and among the managers we view as generating the most attractive returns for our investors.
CLO Opportunity Fund
We have kept the rating-composition unchanged during the final quarter of 2020. At year-end, the fund is 68% exposed to BB-rated notes, 30% exposed to B-rated notes, and 2% exposed to subordinated notes. There is less of a curve for B-rated notes, as these trade more on underlying credit metrics. The expected return for better performing B-rated notes is 700 bps, while notes with weaker metrics have an expected return above 800 bps. For the BB-rated notes, the shorter duration notes yield around 550 bps and the longer running ones yield around 650 bps. The subordinate note is expected to yield around [17%]. In total, the expected return for the fund is [700 bps].
We have made several changes to the portfolio during 4Q 2020. The primary driver has been prudent cash management, rather than credit quality. In early November, we sold a B-rated note from the CLO manager Spire to raise the cash balance and slightly tilt the portfolio more towards BB-rated exposure. In late November, we added opportunistically to three existing BB-rated positions from Voya, PineBridge and Cairn.
The credit metrics among fund’s assets are flat for the quarter. The solvency test (“overcollateralisation test” or “OC test”), which is the primary determinant of whether cash flow should be diverted, has been flat for the quarter. The same goes for the rating composition of the underlying loans. The average price of the underlying loans has steadily risen since April, and we are now just 0.85% below the price we saw in January. The graph below shows the amount of collateral available to cover the fund’s assets, when taking the underlying loans at market values. The graphs show that no asset in the fund has less than 105% collateral coverage.
We have only a few stressed assets in the portfolio. Some of these assets may experience one or two coupon deferrals, but all of these will be paid out subsequently.
Overcollateralisation test at market value
The current environment is one of increased stress and uncertainty, and that is being reflected in the mezzanine CLO notes. A small group of these notes are close to reaching their OC trigger level. This does not mean permanent losses, the structure is constructed this way to protect noteholders according to seniority. It does mean that the underlying loan market has been stressed.
What we are looking into over the next 12 months is likely that some of the fund’s assets will defer coupons but this will not affect our dividend policy. If our conservative base-case scenario does unfold, which we think is unlikely, and defaults does increase substantially, we could experience a couple of quarters of lowered dividends from the fund. This will be followed by a couple of quarters with increased dividends, both compared to the level seen in 2020.
Our plan going into 2021 is to continue with the current rating-composition, as this creates the most attractive risk/return profile to secure our dividend police going forward. We will continue to be very conservative on our B-rated positions, targeting conservative managers. Given the lower re-financing level in 2020, more than 80% of the fund’s assets can now be called. Given the CLO markets current path towards normality, we expect more re-financings to happen in 2021. This will automatically generate additional return, as most of the fund’s assets trade below par. We will reinvest these proceeds along the curve, giving a balanced duration profile, and among the managers we view as generating the most attractive returns for our investors.
Dynamic Credit Strategies Comment: Central bank Domination
This being the first quarterly comment for our new Dynamic Credit Strategies fund it perhaps makes sense to introduce the specific markets in which the fund operates, alongside an overview of how they have performed in 2020.
The fund’s strategy is to find attractive macroeconomic investments, executed using credit indexes. We use the iTraxx indexes for this because they are the most liquid in Europe. iTraxx Main holds 125 of the most liquid investment grade credits in Europe, while the iTraxx Crossover hold the 75 most liquid high yield credits. This is of course just a subsection of the current 3,134 and 787 constituents in the Bloomberg Euro investment grade and high yield indexes, but the iTraxx Main and Crossover have a correlation of above 90% with these. A new iTraxx series is issued every 6 months with fixed constituents. For the last couple of years, the average weekly trading volume for iTraxx Main has been around $7bn.
Several times over the past 5 years, we have been able to enter into levered iTraxx Main positions yielding far more than our analyses showed the expected loss to be. Further, we have taken ‘short’ positions in the iTraxx Crossover when it was cheap relative to the underlying credit risk. Many of these historical positions are now in our new DCS fund. This means that the fund is generally ‘long’ European investment grade corporate bonds and ‘short’ European high yield corporate bonds.
The markets for European investment grade and high yield corporate bonds have been volatile this year. March 2020 was the single largest drawdown in the last 20 years in the Bloomberg Euro investment grade index and second largest in the high yield index. The remarkable thing was that in April, investment grade bonds saw the largest price increase in the last 20 years. The high yield bonds rose in value more slowly. Already in mid-July, investment grade bonds were positive for the year, something that took high yield until mid-November.
One of the dominant forces in the investment grade corporate bond market in Europe, is the European Central Bank (the “ECB”). The International Capital Markets Association estimated that, at the end of November 2020, the ECB owned 25% of all eligible investment grade corporate bonds, or around 8% of all investment grade corporate bonds. The ECB has bought €6bn of investment grade corporate bonds per month in 2020 absorbing a large part of the new issuances and forcing prices up.
This massive buying of investment grade corporate bonds lowers the yield, not only on these bonds, but also on high yield bonds, as investors are forced to take on additional risk to meet return targets.
In short, the technical support for investment grade corporate bonds is very strong. We see a clear support for our primary strategy in the fund, owning investment grade corporate bonds on a levered basis.
The fund was ramped on November 6th, being fully invested from the start, as all investors entering needed to deposit existing CLN positions into the fund. Currently, the fund consists of 6 CLNs, giving investors exposure to 6 different iTraxx Main series, 3 different iTraxx Crossover series, and a range of investment grade corporate bonds and CLOs acting as collateral.
The shortest duration CLN in the fund is running until 2022 and the longest until 2026. Three of the CLNs are in the mature stage of their life (accounting for 25% of NAV), and we are looking to exit these in 1Q 2021.
As the fund invests based on macroeconomic themes, market opportunities typically arise slower than when investing in individual bonds, but when the opportunity arises, the risk/return prospect is typically also more attractive.
As the fund invests on a levered basis, the foundation of all investments is risk management. Specifically, this means that all positions are constructed to limit losses and be able to weather almost all market price scenarios. At the moment, the riskiest position in the fund can weather a market price scenario that is 50% worse than at the peak of the European debt crisis.
This also means that there are periods when prudent risk management prevents us from making these levered trades – as we are in right now. We have a range of other options available, and we are actively exploring these.
Looking into 2021, the primary force acting on the fund will be the ECB. Both Accunia and major investment banks see that the technical support for investment grade corporate bonds will be very strong next year. This is positive for the fund, and we are well positioned to benefit from this. But as we saw in late October, the ECB is not almighty in the short run. Spreads widened some through October, as 2nd wave fears were gripping the market. Our strategy going into 1Q 2021 is to execute a new investment that works in the current low spread environment, while also keeping some of the older maturing position in the portfolio, giving us the possibility to rotate into new investments if market prices should drop for one reason or another.