CLO pricing methodologies and differences discussed

Representatives from Bloomberg, CIFC and Kanerai discussed CLO pricing methodologies, as well as differences between legacy and 2.0 deals during a live webinar hosted by SCI in October (view the webinar here). Topics included changes in the underlying loan market and where to find relative value. This Q&A article highlights some of the main talking points from the session.

Q: How has the CLO market evolved over recent years?
A: Cynthia Sachs, global head, Bloomberg Valuation Service: The market has changed a lot during my time. We are now seeing increased pressure from the investor community and audit community to see CLO portfolios priced by independent third-party valuation providers.

Tranches have historically been priced via in-house proprietary models based on internal assumptions and only on a monthly basis. Increased regulation and auditor demands now require these prices to be validated by outside sources.

Another change we are seeing is a push beyond the traditional CLO buyer base to less conventional investors, such as retail funds, who require daily NAVs that go beyond the traditional month-end process. There is a reach for yield, but in order to attract investors the market needs frequent, independent valuations and that increased transparency is causing a paradigm shift to increased liquidity.

Oliver Wriedt, head of capital markets and distribution, CIFC: We are in the fourth year of the resurgence of the CLO market subsequent to the financial crisis and really have been going from strength to strength. We are on track for a record year for issuance and we attribute the success that the market enjoys today to the strong performance that virtually all funds demonstrated back in 2008 and 2009.

Importantly, the investor composition really has changed dramatically. Whereas the pre-crisis market was dominated by ABCP conduits, by SIVs and by bank negative basis books, those investors do not really exist today, such that we have had to establish an entirely new investor base which is made up principally of US banks and banks across the Asia-Pacific region, notably Japan.

The triple-A class has become far more important than it was before the crisis and the mezzanine part of the capital stack has become much more attractive to banks. Equity investors have also changed away from insurance companies and pension funds to dedicated private equity funds, hedge funds and more opportunistic capital.

The most important change is that the CLO market has become one where an investor can capture total return. It is an actively traded market and investors are drawn to it because they are able to express views. The market has evolved dramatically and pricing CLOs correctly is critical to the success and the growth of our market.

Q: How do changes in the loan market affect CLOs and modelling assumptions?
A: Wriedt: Modelling has become quite a bit more challenging post-crisis because the underlying collateral market has changed dramatically. We have seen the introduction of Libor floors to make up for the low levels of Libor, thereby introducing duration risk into the structure really for the first time, as well as OIDs and call protection.

The underlying collateral pool today exhibits a modest amount of duration risk, which is obviously enhanced through leverage through the equity tranche, as well as a little bit of convexity associated with the original purchase discount and call protection. As a result, it is a very different proposition to the quasi-static pools we were looking at pre-crisis, where loans were priced on a very standardised basis without floors, without discounts and certainly without call protection.

These features were introduced to make the underlying asset class more attractive, but they have also made it more difficult to model transactions. Repricing has also become a key concern and we saw a lot of repricing early in the year; it is really anyone's guess what next year will bring and whether a strong credit market will lead to another wave of repricings.

Q: Which are the key factors when pricing CLOs?
A: Jesse Knapp, md, Kanerai: At Kanerai, the first thing we do is identify the factors that traders and portfolio managers care about when they trade the sector, observe how these various factors differentiate the pricing between one tranche and another, and then apply what we learn across the universe of tranches. This requires a lot of work integrating individual tranche metrics and broad market data.

Once we have calculated the various metrics, we run a comparison against a very broad data set of market information, so that we can understand how the market is pricing different deal and tranche characteristics. Specific observations on a tranche are always valuable, but that value of such observations declines over time. We utilise direct observations, as well as observations of similar securities to inform where the best approximation of trading levels would be for each individual tranche in the universe.

Q: What are the pricing differences between a 1.0 CLO and a 2.0 CLO?
A: Knapp: The differences begin with portfolio quality, as the 2.0 deals have higher overall portfolio quality than the 1.0 deals, which means lower default rates but also greater exposure to asset repricings. If you look at 2007 deals versus 2012 deals, the 2012 transactions have faster asset repricing speeds to the magnitude of a few CPR relative to the older transactions.

Another difference is the deleveraging of the 1.0 transactions. The composition of the assets is changing and the average life is shortening, so you really need to take into account the most recent data, whereas on 2.0 transactions the portfolios are changing but the structures are not because they have not passed their reinvestment period and so the subordination levels are reasonably constant.

Another area of difference is that the 1.0 transactions have more flexibility on manager reinvestment, especially after the reinvestment dates. Bond coupons also differ and call risk is something we look at very closely.

Q: How should managers approach these differences?
A: Wriedt: Credit risk is all-important and the risk factors for CLO 1.0 deals are substantially different from the 'clean' collateral that is associated with CLO 2.0s. With new collateral, there are the Libor floors, OIDs and call protection, all of which make it more attractive than pre-crisis collateral.

Deleveraging is a key performance driver in CLO 1.0 and leads to increased concentration risk. As it is often the good borrowers that refinance and not the bad borrowers, at some point you will likely reach a point where you have a more concentrated portfolio and are more exposed to some of the more challenging names. That introduces different credit risks from what you will find in a 2.0 deal.

There is also documentation risk and although documentation is different from deal to deal, it is far more standardised among 2.0 deals. Documentation needs to be studied very closely, particularly as it relates to the manager's ability - and frankly willingness - to invest post-reinvestment because at times managers have taken liberties to interpret documents freely in such a way that those have been managed to the clear detriment of the debt investors, solely to the benefit of extending the equity arbitrage.

Finally, and perhaps most importantly from our vantage point, the total return opportunity in 1.0 is just not what it was. Prices have rallied, so it is now the discounted 2.0 market which is offering the ability to capture positive convexity.

2.0 deals provide the opportunity to capture total return across the entire capital stack and that has been the game-changer that has attracted real money investors. You can express a view and it has become a very attractive, very cheap tradable market.

Sachs: From talking to clients, that is the view right across the marketplace. As investors are looking across many asset classes on a relative value basis, they continue to focus on CLOs because they are cheap, but of course they need valuations to support that.

Q: What are the specific considerations for valuing equity tranches?
A: Knapp: One way we look at the sector is to start with the market value NAV of the equity if the deal were to be liquidated today. When we map and price all the assets backing all the deals throughout the universe, we can get a feeling for what the liquidation values would be.

Beyond market value NAV and liquidation value, there are several other characteristics which need to be taken into account to determine the valuation of an equity tranche. We also look at the thickness of a tranche, the yields across different scenarios and other aspects, such as portfolio liquidity and the collateral manager.

Q: How is call risk built in under different scenarios?
A: Knapp: Call risk is a factor we include in our model. Many 2.0 deals are being priced at a discount to create total return activity and, as that total return is realised and prices get into the par to 101 or higher range, the upside is going to be limited.

Q: To what extent do regulatory constraints impact pricing?
A: Sachs: Regulatory intensity is playing a significant role in the CLO market, in structured products and in corporate credit in general. We are watching the regulatory dynamic very closely, particularly in structured products, as the market continues to struggle with the uncertainties around risk retention.

Regulation and audit mandates are pushing the envelope to bring greater transparency to the market and that is particularly important for new investors. The asset class has historically been opaque and this big push to open the market up and get more transparency is a healthy progression.

Q: How important is standardised pricing?
A: Wriedt: Returns in Treasuries, municipal bonds and investment grade bonds have been disappointing and against that backdrop CLOs produce compelling absolute and relative returns. Pricing and transparency have been the predominant barriers to entry and, as we collectively work away at this barrier, it is going to open up the asset class to a much larger investor base and the attractiveness of the asset class is as compelling as it has ever been, given the lack of alternatives.

Q: How can the lack of transparency be overcome?
A: Sachs: The BVAL/Kanerai solution makes a lot of sense for the marketplace. Through Kanerai we distribute daily pricing on CLOs, which involves very dynamic model-based relative value prices that are generated on a consistent basis.

It is not done in a black box way; rather, the market can look at daily prices which are dynamically derived from current market spread. This perspective and that kind of independent transparency are revolutionary for this market.

Q: Where is relative value?
A: Wriedt: If you look at the first generation of CLOs, there were certain truths, such as 20% prepayment speeds, 2% annual defaults and 70-75 cent recoveries. The market used those assumptions to price equity and then investors would run variations on that same theme, but those metrics do not apply to today's market.

We have not seen such low prepayment speeds for four and a half years and the 2% CDR also seems inappropriate, given the prolonged period of little to no defaults that we have observed, particularly as it relates to the newer clean collateral. We think it makes more sense to assume lower defaults for a period of time and then see those stepping up as the credit cycle ensues.

More importantly, reinvestment assumptions were not controversial pre-crisis in that all collateral priced somewhat uniformly, but reinvestment assumptions in CLO 2.0s are critically important and there are very different views on where the market is headed and whether those should be wider than where the market is pricing today or substantially tighter. That introduces a significant amount of variability into a given valuation exercise.

It is probably not too controversial to suggest that the CLO 2.0 triple-A opportunity is, for those investors who can afford to be in an investment that yields less than 2% to maturity (based on today's Libor, at least), the cheapest part of the capital stack. However, the total return opportunity, particularly in junior mezz, is compelling. As far as equity is concerned, we think 2.0 equity is interesting, particularly if there is transparency.

The 2.0 market is compelling across the stack, but we do also recognise the appeal of very short-duration 1.0 opportunities. Given where prepayment speeds are, there is some certainty around having a 0.5- or one-year WAL opportunity that obviously does not exist in the 2.0 market, but generally we would skew the discussion to relative value being squarely in the 2.0s.

Q: What are the prospects for the European CLO market?
A: Wriedt: The challenge for the European market is that there is nowhere near the depth of market that we have in the US. Absent the ability to select collateral carefully and to build diversified high quality portfolios, introducing term leverage to a concentrated pool where there is a lot of selection bias introduces significant risk.

If you look at the performance of European CLO equity versus US equity, it has been a very different experience and, until the European market grows to a point where you can truly diversify portfolios, we think that market is going to continue to be challenged. We have obviously seen a resurgence of the new issue transactions, but we continue to be concerned by the small absolute size of the European market. Whereas the loan market in the US is outgrowing the high yield bond market significantly, that is not the case in Europe where high yield bonds continue to rule the day.