KopenTech looks at US CLO trading trends in 2020 and their likely future impact

In a period defined by a pandemic, social turmoil and an election, CLO investors increased their use of electronic trading to engage in a more efficient exchange of securities.

With this increase in volume came an increase in data.  We highlight some of the US CLO market trends, including how increases in trading volumes have been handled by investors, and expectations for market health going forward.

CLO secondary trade volume hits record highs

2020 was a watershed moment for trading CLOs as volume swelled over 60% to US$185bn from 2019 volumes as reported by TRACE. Competitive bidding via BWICs also increased 54% to US$60bn [or from US$39bn in 2019].

Leading the total trade volume were triple-A tranches, which represent over a half of the typical CLO structure.

BWICs vs TRACE

CLO trading has been conducted in two forms: BWICs and bilaterally via bank trading desks. Competitive bidding is proven to produce higher execution price by auction theorists, however BWICs have represented only approximately one-third of the total TRACE reported trade volume for several years.

Why have BWICs accounted only for 30% of total CLO trading?  The answer lies in the traditionally labour intensive, time-consuming process of conducting a BWIC, to date.  In 2020 however, we saw the emergence of electronic trading platforms, which are expected to transform the manual nature of conducting a BWIC, increase its use and therefore increase BWIC trading percentages.

CLO equity quickly regains lost ground during 2020

CLO equity has been traded more frequently in recent years as the CLO market has been gaining liquidity. When Covid hit the US in the spring of 2020, CLO equity trading came to a halt. There was no forced selling or panic, indicating a patient investor base. This encouraging trend came in sharp contrast to the 2015-16 energy crises. Despite the no-mark-to-market of CLO collateral, marks and valuations of CLO equity dropped more than 30% in 2020; however, the lack of trading, points to investor’s confidence in the asset class.

CLO equity trading returned in the summer of 2020 as valuations rebounded and we saw $2.2bn trade by year end.

Many Happy Returns: CLO equity yields

With an increase in demand came strong returns for CLO equity investors. CLO IRRs increased from low teens at the onset of 2020 to mid-30s by year end. Tranche purchases in May 2020 produced quick gains for investors as yields were normalising and settling in the high teens by December.

AMR builds momentum

Over the period of January 2020 through February 2021, investors have seen three Applicable Margin Reset (AMR) refinancings come to market, representing over US$1.5bn of debt. TCW 2019-1 was refinanced twice over that time period, the third auction was Seix’s Mountain View XIV. Investors showed tremendous interest as each auction was over three times subscribed.

AMR remains particularly appealing to CLO equity investors due to its time efficiency, cost effectiveness and return-enhancing process. More auctions are expected in the coming year as six additional AMR deals are either out of their non-call or approaching the end of non-call in 2021.

Prices show a V-shaped recovery

Prices across the CLO capital stack were temporarily depressed during March and April. The upper part of the capital structure with investment grade ratings quickly rebounded to their pre-Covid levels by Mid-Summer.  Lower rated tranches – double-B, single-B and equity – while seeing a comeback, were still lagging their pre-Covid levels by end of 2020. The early months of 2021 saw a further rally across the capital stack.

Déjà vu all over again: most liquid managers

Some CLO managers’ paper was traded more frequently than others. Leading the pack were bonds from Credit Suisse, CIFC Asset Management and Prudential, each with over 400 listings of their securities on BWIC.

Most liquid bonds

Liquidity is a relative concept. As we can see, it ranges significantly for different parts of the CLO capital structure. While a liquid triple-A bond might trade over 30 times over the course of a year, a liquid CLO equity tranche may have only three transactions. Below are the most liquid triple-A, triple-B, double-B and equity bonds of 2020. Please be aware of the inherent lower bias in these numbers. The only available rating data is based on BWIC volumes which constitute roughly one-third of the total. The TRACE-reported total results do not provide CUSIP or rating breakdowns.

Covid caused a move to issuance of short-dated deals

CLOs are typically issued with a five-year reinvestment period and a two-year non-call period. Initially, the Covid market impact prompted spreads to widen significantly and issuance paused for a month. In efforts to restart the new issue market, managers printed short-dated deals, with two or three years of reinvestment period and one year of non-call instead.  The shorter transactions were lower risk for investors and provided a useful bridge to restart issuance.

New issuance during April 2020 to August 2020 consisted entirely of short-dated deals.  Longer-dated deals did not return to the market until September.

The next big thing: electronic trading for CLOs

Electronic trading continues to be on the rise: equities, treasuries and FX have made the transition and we are seeing an increase across credit products with investment grade bonds leading the way and high yield bonds following behind.  There are even inroads for electronic trading of leveraged loans.  According to Greenwich Associates, investment grade corporates trading electronically increased 40% from January 2019 to November 2020. This trend is starting to translate into CLOs.

With new issuance growing at a rate of 20% per year, investors are trying to find more efficient ways of trading to replace the typical manual and time-consuming processes for running a BWIC.

Secondary trading through electronic platforms continues to gain traction with investors and broker-dealers alike. The benefits to the market are potentially innumerable and could ultimately help it to grow.