LFI interviewed David Lerner, head of Structured Credit, and Jordan Barrow, co-head of Liquid Credit at Shenkman Capital Management Inc., about the demand for CBOs, particularly from insurance; how the upcoming election could increase market volatility, presenting opportunities for CBOs; the value of bond buckets in BSL deals; and the structural advantages of CBOs over ETFs. Shenkman Capital Management Inc. is an independently owned traditional and alternative credit manager. The Shenkman Group of Companies manage approximately $34.7 billion of assets, including seven active CLOs and three active CBOs totaling $3.4bn billion.
Where are CBO AAAs pricing compared (basis) to BSL deals and what’s the potential impact from the election?
Shenkman: In our most recent deal, which priced over the summer, the AAA tranche came about 40-50 bp wide on a spread basis to BSL. However, this was the first CBO to come to market in more than two years. CBOs typically tend to price more in line with middle-market CLOs, because their market depths are more comparable. Notably, we saw considerable demand for these fixed-rate tranches given the higher interest rate environment at the time – particularly from insurance clients. The strong demand did enable us to eliminate the make-whole feature that CBO AAAs have historically enjoyed, which we believe will benefit the transaction over the longer term.
With respect to the election and the potential impact on the CLO/CBO markets, we will not make predictions on either the outcome or the market’s reaction. Rather, we expect that market volatility will pick up as we near the conclusion. We saw a similar market effect when President Biden was elected. Given our traditionally active trading strategy, this projected volatility would present an opportunity for our CBOs to rotate their positioning, build excess par and provide convexity benefits in the future.
Where are you seeing opportunities for relative value in BSL CLO and CBO tranches (new-issue and secondary)?
Shenkman: When market conditions support new CBO issuance, we historically observed that the demand from fixed-rate tranche buyers seems to be significant, which in turn normally improves the ability to create the deal and capture the necessary interest arbitrage. We believe this demand is strong due to the scarcity of highly rated fixed coupon investment opportunities in the CLO market. Importantly, while the current high-rate environment elevates the CBO’s cost of capital, a subsequent decline in rates would increase the value of the equity holders’ embedded options. We think, based on our prediction of a subsequent decline in rates, this enhances demand for new issue CBO equity.
Along with other fixed-income asset classes, CBO and CLO tranches have tightened materially over the last 12-18 months, but we think both still present compelling relative value versus comparably rated assets. In the primary market, we are finding attractive relative value in CLOs that have reset and cleaned up their portfolios. These deals often price wide to comparable new issues. In the secondary market, there is a more diverse set of investment profiles available, offering a wide range of coupons, duration and portfolio quality. While many of these profiles currently trade at a premium, investors may find value in short paper priced near par, or in longer, call-protected paper with higher coupons.
What’s your view on the use of bond buckets in BSL deals?
Shenkman: We think bond buckets in BSL deals can be very valuable. Many aspects of the bond market can help managers increase diversity, build par and generate excess spread. We believe the high-yield market generally offers exposure to stronger credit profiles, along with the option to trade duration versus credit risk. Further, the high-yield market is often influenced by the various ETF flows. These vehicles seek to maintain a very low tracking error, and thus their trading patterns can create idiosyncratic opportunities, where fundamental values diverge from market prices. In sum, these high-yield market attributes can allow the manager to pick up convexity by buying higher quality credits at discounts to par, which may not be as available in the loan market.
The ability to access the bond market selectively can also increase the manager’s optionality. In particular, it can enable the manager to be much more proactive in selling down credit risk when they first start to see signs of weakness. The bond bucket removes the manager’s requirement to replace the par in the loan market, which may not offer attractive credits at the necessary discount to par.
What are the main differences between the CBO and CLO structure and how does Shenkman take advantage of that?
Shenkman: Some of the most obvious differences are that CBOs are less levered than CLOs, issue fixed-rate tranches and provide managers with significantly more latitude when constructing portfolios. We analyzed these structural differences, among others, and concluded that CBOs could provide investors a vehicle with long-term non-recourse leverage, coupled with significant trading flexibility, relative to CLOs, in order to produce attractive cash-on-cash returns and potential for capital appreciation. Our CBO strategy starts with a high-quality base of credit instruments. When the market dislocates, we tactically rotate out of this base and into assets that have experienced greater price declines – such as loans, investment-grade bonds, convertible bonds and core high yield. When the market recovers, we tend to reposition back to a more defensive portfolio. History has shown that the market provides many such volatility events, and we expect similar opportunities to present themselves in the future.
Why invest in a CBO vs. an ETF?
Shenkman: CBOs and ETFs are really very different investment options. We believe that CBOs are highly complex vehicles that require both structural and portfolio management expertise to execute successfully. ETFs employ model-based portfolio management, with the primary objectives of replicating market or index returns and providing a very high level of liquidity and market beta. CBOs are long-term, locked-up vehicles that seek to deliver much higher returns through a combination of structural leverage and sophisticated investment and trading strategies.
David Graubard
david.graubard@levfininsights.com
+1 646 361 6095
