Identifying relative value in the current loan environment, where asset spreads are compressing, was a key theme at IMN's recent European CLOs and Leveraged Loans conference. Against the backdrop of rising refinancing and reset volumes, call optionality and manager style emerged as strong contenders.

From a relative value perspective, Natixis ABS/CLO trader Peter Cui said that in terms of carry, older double-B and single-B European CLO bonds trading at below par trade around 50bp tighter versus recent deals trading at above par. "From a short-term trading standpoint, given the rate of loan prepayments, CLO 1.0 deals are delevering quickly and therefore improving from a credit perspective and in terms of call optionality. But from a buy-and-hold standpoint, 2.0 junior debt is more attractive."

However, Aza Teeuwen, partner and portfolio manager at TwentyFour Asset Management, noted that double-B and single-B bonds - specifically early/mid-2016 vintage double-Bs and 2014/2015 vintage single-Bs - have been the sweet spot for his firm in 1Q17. Prytania Investment Advisors senior investment analyst Marcus White added that while triple-A rated European CLO bonds have long represented the best risk-adjusted value versus other European risk assets, given the severity with which they have tightened, even that is becoming less clear.

"Single-Bs have more room to run, if you compare them to their 2014 tights. CLO equity is interesting, with CLO liabilities at post-crisis tights and up to 50bp tighter than where we have seen them in the past few years - that's an extra 5% of excess spread on a 10x levered CLO," he observed.

Meanwhile, when assessing a CLO manager, Sheil Aggarwal, head of valuations at SCI Valuations, said that a first step is to identify whether it is debt-friendly or equity-friendly, depending on where in the capital stack the investor plays. Cui noted that he is neutral on CLO managers at the top of the capital stack, but at the bottom of the capital stack, manager style makes a difference because it highlights whether they are picking the correct credits.

"When choosing a manager, the biggest concerns should be erosion of par and lower WAS. With a five-year reinvestment period, if there is a market correction in, say, 18 months, a good manager can take advantage of the lower loan prices and deliver a good equity return because the tight liability spreads are already locked in," he explained.

White said his firm tends to avoid larger and prolific CLO managers when buying lower in the capital structure, given the risk they typically 'buy the market', and is more concerned about performance. "We prefer managers to actively trade, who demonstrate an ability to build par. We also look for disciplined underwriting - do managers deliver on what they said they would, particularly in terms of portfolio ramp?"

As well as what a manager's rationale and investment processes are, Teeuwen recommended that investors question whether it will still be around in six years' time. He added that larger CLO managers may struggle to exit problematic names, but achieve a decent allocation in the primary market, while it's often the opposite for small managers.

"Secondary market liquidity is strong at the moment, but finding bonds in reasonable size can be challenging," he suggested. "NAVs have peaked and defaults will begin rising at some point. If you're a CLO equity investor, I would stick with smaller, more conservative managers, with liquid holdings, that are more nimble and can pick up spread in a sell-off."

Another factor investors should be aware of is how a manager treats defaults. Anton Spadar, senior analyst at Chenavari, cited the example of CLO-friendly HoldCo tranches of AVR loans, which a few managers treated as equity, others sold and some kept, which paid off for equity investors.

Chris Whitcombe, quantitative analyst at 400 Capital, noted that from a CLO equity perspective, the investment horizon is critical in the current environment. "Currently, the initial arbitrage is weak, so a long investment horizon is required to allow time for the equity optionality to add value but also for selected managers to outperform. An area where managers can add value is through the active use of fixed-rate buckets and the inclusion of second tier loans in the portfolio, where appropriate to their skill-set and style," he observed.

Liquidity has been greater at the bottom of the capital stack and more constrained at the top, in terms of being able to buy paper in good size, according to Cui. He suggested that sellers will still get good execution when selling, even for small clips.

Cui added that refinancings and resets have affected secondary activity. "As a CLO gets closer to the end of its non-call period, trading tends to dry up as participants begin pricing to the first call," he explained.

Panellists indicated that call optionality could increase as deals are reset, due to limited loan supply for new issues. Equally, generating alpha via refinancings and resets could make CLO equity a more interesting proposition.

Looking ahead, Matthew O'Sullivan, head of commercial securitisation at M&G Investments, sees no reason for the current spread tightening trend to ease off. He pointed out that there is a floor, given US CLO spread levels and the fact that most CLO investors require a premium over investing in more vanilla securitisations, but doesn't envisage any widening without some shock to the market.

CS