⚡️What to Make of the Credit Cycle. Part 28. (Long Financial Ingenuity.)⚡️
Nobody questions that we’re late stage at this point. Lest you have any doubt, consider the following:
1. Enhanced CLOs
A growing number of money managers are embracing a new strategy designed to benefit from volatility in junk-rated corporate loans, a sign of building worries about riskier borrowers and the market that supports them.
Since November of last year, three different money managers have issued $1.6 billion of so-called enhanced collateralized loan obligations that are set up to hold a much larger amount of loans with extremely low credit ratings than typical CLOs. At least two more managers are expected to follow suit in the coming months.
The emergence of the enhanced CLOs underscores investors’ growing belief the U.S. economy is due for a recession after more than a decade of expansion. It also reflects particular concerns about corporate loans, starting with a decline in their average credit ratings. Since 2011, the amount of loans rated B or B-minus—just above near-rock bottom triple-C ratings—have ballooned to 39% of the market from 17%, according to LCD, a unit of S&P Global Market Intelligence.
CLOs are weird beasts with certain idiosyncratic limitations. As just one example, many CLOs are limited to a portfolio that includes no more than 7.5% of CCC-rated loans. Upon a rash of downgrades during a downturn, this would force these CLOs to sell their holdings, pushing supply into the markets and inevitably driving down loan prices. An opportunistic buyer could stand to benefit from this opportunity. These newly established CLOs won’t have these constraints; they could “stock up to half their portfolios with triple-C debt.”
By way of example:
Investors say there is ample evidence that the limited ability of CLOs to hold triple-C loans creates unusual price moves in the $1.2 trillion leveraged loan market.
In one example, the price of a loan issued by the business-services company iQor Holdings Inc. dropped from around 98 cents on the dollar to 85 cents last summer immediately after Moody’s Investors Service and S&P Global Ratings downgraded the loan to triple-C. Data showed CLO holdings of the loan falling sharply at the time.
Ellington Management Group, Z Capital Group and HPS Investment Partners are the funds looking to take advantage of these market moves.
2. Retail CDOs
Ahhhhhh, Wall Street. JP Morgan Chase & Co. ($JPM) apparently wants to expand markets for credit derivatives, including synthetic CDOs. Per the International Financing Review:
The US bank launched its Credit Nexus platform earlier this year, according to a person familiar with the matter. The platform is designed to simplify the cumbersome process investors usually face to trade derivatives, including credit-default swaps, CDS options and synthetic collateralised debt obligations, according to a client presentation obtained by IFR.
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