SHINING STAR Northlight steers funds to strong 2018 - COMPUTING CREDIT
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JUNE 2018 ISSUE 38 www.altcreditintelligence.com
Published By
SHINING STAR COMPUTING LIFE AFTER
Northlight steers funds CREDIT LIBOR
to strong 2018 First big data, now DealVector on looming
alt data Libor switch
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CONTENTS 03
The CDS market
doesn't have a great
reputation
T
he CDS market doesn't have a great reputation
Michael Lewis, John Stewart, and now the Pope have THIS ISSUE
taken aim at the financial product.
Alt Credit is no place for theological and moral questions
of this depth. But it is the place to discuss the recent contro-
versies in the market, and what the real problem is: liquidity. 04
The good news is that CDS is actually on the up in many senses, its regula-
tors are making progress on some sticky problems, and liquidity is improving.
We also take a look at the volumes of data now available to credit man-
agers. Technological advances and a spirit of openness has allowed ABS and
MBS managers in particular to move from ploughing through documents to
building models and hypotheses. But how far into the data can and should
they go? ANALYSIS
04 CDS fights back
Credit derivatives have taken a lot of heat
The CDS trades which hedge fund managers in the press, but the product could be on
are putting on have become simpler, focusing the up
on single names and indices” 08 Data gets bigger
Ed PArker, Mayer Brown, page 05 Credit is at a tipping point, as data gets
bigger, better and possibly finally useful
Derivatives were the talk of the town in May. The town in question being
11 March in CLOs
The CLO market is on fire, but managers
the Vatican City. Events just outside the Holy See also conspired for an inter-
share concerns over lax lending standards
esting CDS story as Italy roiled markets. Briefly.
CLO markets continued to plough ahead in the month, but worries about 12 April in derivatives
the collateral are mounting. Managers have pointed to Ebitda adjustments as Hovnanian's trade finally comes to an
a particular bugbear in loan documentation. end, as an Italy arbitrage opens, then
DealVector has highlighted one of the problems all parts of the CLO promptly closes
market and structured fi nance markets face: poor communication lines. The
expected phase out of Libor is set to emphasise that problem. Luckily, tech-
nology can help. COMMENT
A move away from QE could be even more painful for markets. BlueBay
describes how it plans for the future.
14 Life after Libor
Communication in the structured credit
As you read this I will be cycling my way through France and probably
world is hard enough, replacing Libor
already very sore and wheezing my way up a mountain. There's still time to
makes it urgent
donate to a great cause in Duchenne UK by visiting Virginmoneygiving.com
and by searching for HFM Wheelers.
16 Getting used to expecting
the unexpected
BlueBay plans for a more volatile market
Jon Close, head of content, Alt Credit
after central bank liquidity
j.close@pageantmedia.com
DATA
27 Performance data
Alt Credit ’s performance tables
JUNE 2018
04 ANALYSIS
JUNE 2018
ANALYSIS 05
The CDS markets have taken a battering recently, despite
some significant improvements
By Jon Close
T
he CDS industry has come “Ironically, in many ways the CDS trades
under attack from no less which hedge fund managers are putting on
than the Pope, while its latest have become simpler, focusing on single
controversies have moved to names and indices,” says Edmund Parker,
the front pages of the popular global head of derive at Mayer Brown in
press. Meanwhile within the London. “Whereas before 2007 they were
industry, Isda has been dealing with a moun- often focused on products like CDOs of ABS,
tain of issues ranging from new bank struc- basket trades and exotic products like CDO
tures, missing financial documents, uncer- squared.”
tainty over some of its largest sovereign names
and managers trying to play its decisions. Single names
The biggest problem the market has faced, Single name CDS has been a different story.
however, is declining popularity. Investors have rarely felt the need to hedge
But the industry is fighting back. individual bond positions in recent years, and
Isda has successfully implemented some liquidity has been driven by indices.
common-sense reforms and the organisa- A number of proposals, led by IHS Markit,
tion is making noises that it will continue to have sought to address this in the last few
update its framework. The CFTC lent a hand years, with mixed results.
to nudge bad actors into line. Meanwhile, vol- Increasing the number of issuers in the
atility and new structures are breathing life high yield indices had limited success, they
back into the single name market. have rarely held on to the extra liquidity once
out of the index.
Volumes are back (for some) Another change has been much more
Numerous sources told us that the biggest push warmly received by markets. Single name
back they got back from investors and managers CDS switched from a quarterly to a semi-
wasn't the bad press, or the headline trades – annual roll. "The move to two annual rolls a
The return of volatility, since February,
coupled with the demand from bespokes has
meant there has been a much healthier two-
way market in CDS in general”
David Meneret, Mill Hill Capital
but that the product wasn't liquid enough. year has also helped to improve liquidity, it
But volumes in CDS index trading have makes much more sense to roll along with the
actually kept up relatively well after the dust index," says Erlandsson.
settled from the financial crisis, and European
sovereign crises. CSO 2.0
"If you want to add or remove credit risk The biggest factor improving single name
from a credit portfolio, there aren’t really any liquidity, has been the re-emergence of the
other products that are sufficiently close to bespoke CDO (or CSO) market.
the asset and have sufficient liquidity," says These deals comprise pools of typically
Ulf Erlandsson, CIO at Strukturinvest. around 100 issuers, with investors selling pro-
"From an analytics standpoint, CDS indi- tection against tranches of the risk in the pools.
ces are very clean," adds Erlandsson, "When "The banks are intermediating between these
you start doing an ETF or a TRS, you have to structures and the markets, and so we’re now
do lot more analysis on the weighted credit seeing CDS B-wics of banks requesting bids for
spreads, duration on the underlying bonds, protection on the names in the bespoke struc-
the whole bond curve." he adds. tures," says Mill Hill Capital CIO David Meneret.
JUNE 2018
06 ANALYSIS
"The return of volatility, since February, That said, the extra liquidity these deals A Noble privacy
coupled with the demand from bespokes has – and the increased activity in the indices – One area which shows little sign of movement
meant there has been a much healthier two- brings is limited to the names involved. is in Isda's need for documentation to be
way market in CDS in general." "The names that are actively traded in the public in order for it to make a decision. This
Deals such as these also came under a lot high yield space in bespokes and indices are came to a head recently by Noble, whereby
of criticism post-crisis, not least because liquid, but liquidity outside those names is Isda couldn't prove that a subsidiary had a
they involved a lot of leverage. But 'CSO 2.0s' dropping,” says Meneret. guarantee to the parent company.
have some key differences to their pre-crisis "If something goes wrong at the company,
brethren. Banks: Where the real action happened a hedge fund which may have a CDS position,
"Pre-crisis you could be levered as high as European banks had been one of the most liq- and knows something’s happened, can’t put
200 times on some AAA tranches; the most uid areas of the market, especially after naked it in front of the determinations committee
leverage you could potentially do now would buying of protection against sovereigns was because the agreements aren’t public," says
be 80 times," adds Meneret. "But, I literally banned, and managers began using banks as Parker. "Whatever the truth of the matter is,
don’t know anybody who is using that much proxies. it can only be judged on publicly available
leverage." But under the various capital requirement information. There are some tools available,
Another key difference is that banks are regimes coming from Europe, banks have but there are still times that you can’t get the
selling the whole capital structure of these been continuously updating their capital information out there."
deals, and only executing the trades once both structures, adding new layers at the top and
sides of all the contracts have been found, bottom, and CDS markets have been scram- Italy
leaving little risk on their own balance sheets. bling to keep up. Italy also recently highlighted another poten-
UK banks created a new senior HoldCo tial for an issuer to not be quite as protected
entity to issue senior debt, and while it took as investors might hope.
some time, CDS against these new entities The rise of populist parties to power
eventually became the more liquid senior con- briefly sent bond yields and CDS spreads
tracts for UK banks. soaring, especially as there was initially a risk
“At the roll in September 2017 we added the of redenomination if Italy chose to abruptly
HoldCo entities as the reference entity for UK drop the euro as its currency.
names in the index, and we’re now This raised an interesting question for the
seeing those as the most liquid CDS lawyers, as there are currently two sets
entity in the capital structure. of CDS definitions, which treat redenomina-
We’re seeing liquidity in both tion differently.
the hold co and the OpCo.” As spreads blew out on Italy, a gap opened
says Gavan Nolan, a director out between 2014 CDS and 2003 CDS, as
in business development and traders believed that the 2003 wouldn't trig-
research, fixed income pricing ger if Italy left the eurozone. IHS Markit's
at IHS Markit. French banks Nolan felt compelled to take to blogging, in
went down a different route to a post that concluded: "In short, if the Italian
solve the same problem. government were to quit the euro, 2014 defi-
“Since the last index roll nition CDS contracts would be more likely to
we now have the three French default than 2003 definition, but it isn't quite
banks included at what we call that straightforward."
the SNRLAC tier, which reflects It appears that corporates are more likely
the fact that they’re issuing senior to feel this sharply, and this question is
non-preferred debt,” says Nolan. becoming increasingly moot, as 2003 con-
This was a more complex issue as it tracts become increasingly rare, and calm has
required a new kind of contract which spec- returned to the market.
ified the new tier of securities, rather than
having a clean new entity to reference. The GSO trade
“It was a discussion at Isda level between One trade in particular has brought CDS
dealers, investors, vendors and infrastructure protection to the attention of commentators
providers,” says Nolan. and pundits: GSO's recent attempts to trigger
The fact that these multilateral discussions contracts on New Jersey-headquartered con-
were held before a contract was even written struction firm Hovnanian.
highlights the growing maturity of the CDS Under a deal, Hovnanian would trigger
market. CDS in exchange for cheap financing from
“It’s a standardised product now and has GSO.
been for some time, with input for prod- GSO pulled a similar move in 2013 with
uct rules from both dealers and investors. Spanish gaming company Codere, with out-
Whereas before it was dominated by dealers, rage even reaching HBO programme The
you now get a much more holistic picture Daily Show. But this time it’s different.
across the end users,” says Nolan. Solus Alternative Asset Management, a
JUNE 2018
ANALYSIS 07
seller of the CDS, immediately took to the Erlandsson. "There are technical aspects to are held by mandate-driven funds, which
courts. A federal district judge could not pre- the CDS market, and you need to be an adult means price discovery can be lacking.
vent the trade from going ahead. Instead, it about that and go in with your eyes open." "There is no doubt in scientific literature
laid the blame at the feet of Isda’s determina- "GSO is really a very ‘idiosyncratic’ risk that the efficiency of a market segment is sup-
tions committee (DC), which decides when a and should not act as a template for oth- ported by the existence of derivatives instru-
CDS has been triggered. ers," says Jochen Felsenheimer, co-founder ments and especially hedging tools," says
But then the CFTC got involved, say- of Munich-based Xaia, but argues that the Xaia's Felsenheimer. "This is true for equities,
ing that it was looking into the question of continuing functioning of the CDS market commodities and for credits"
whether engineered defaults could be classed requires a functioning of the 'insurance prin-
as market manipulation. ciple'. "Therefore, it is a must for the Isda to Things are clearly changing
After initially rejecting several calls to act, solve such ‘situations’ to strengthen the CDS One takeaway is that timing is everything in
Isda launched a consultation over narrowing market." this market. The Hovnanian settlement and
its definitions of default in order to prevent the fast-moving events in Italy put the entire
such trades. Existential threats market in a different place, just as this issue
Goldman Sachs found itself facing off But the case still opened CDS up to an exis- was preparing to go to press.
against GSO but backed out and unwound its tential crisis; and when the Pope takes aim at But more generally the CDS is constantly
positions. Later both GSO and Solus threat- an industry, the questions about its viability evolving, "The first set of materials produced
ened to squeeze the other's position as the become even more existential. by Isda was 18 pages long. Now, with all the
situation looked set to escalate. The Vatican released a document which different rules; the definitions, auction set-
But, just as Alt Credit was preparing to go referred to CDS as a ticking time bomb, tlement rules, DC rules, its 230 pages," says
to press, news broke that GSO and Hovnanian bemoaning the “ethical void which becomes Parker, "We’ve seen from equity derivatives
had settled their dispute. "We are pleased that more serious as these products are negotiated markets, that developments need to be done
Hovnanian CDS will now reflect the actual on the so-called markets with less regulation over time as an evolution. 2014 definitions
creditworthiness of the company," said Chris (over the counter) and are exposed more to aren’t the last set of definitions you’ll see, I
Pucillo, chief executive officer of Solus. the markets regulated by chance, if not by wouldn’t be surprised to see 2022 defini-
tions."
Erlandsson's Glacier Impact fund would
like to evolve it further, the extra liquidity
There are technical aspects to the CDS CDS allows could pave the way for a more
environmentally friendly way of managing
market, and you need to be an adult about credit risk.
that and go in with your eyes open” "We can take a CDS index, and buy protec-
Ulf Erlandsson, Strukturinvest tion or underweight on the ‘brownest’ names,
and sell protection or overweight on the
greenest names, using the ECOBAR frame-
work as an optimisation engine for finding the
Akshay Shah, the mastermind behind this fraud, and thus take away vital lifelines and weights that 'green up' the portfolio the most
strategy (and the scourge of many trading investments to the real economy.” while keeping the tracking error low."
desks), has left the firm and registered his This isn’t the first high profile criticism of
own company, Kyma Capital, according to CDS, and the wording largely echoes Warren Gaining access
UK Companies House filings. While this may Buffett’s comments that CDS contracts were All this is well and good, but accessing the
give him more of a free rein to pursue even weapons of mass destruction. In recent years, market has become more of a patchwork. The
more of these trades, it's unlikely that Shah The Big Short and the 2011 “London Whale” move from bilateral Isda agreements with
will have the kind of firepower than availa- scandal also kept the product high on the list funds and dealer to central clearing parties is
ble at GSO, and fewer levers to pull (for now of financial bogeymen. still only partial, particularly for single names.
at least). The crux of this criticism was highlighted Meanwhile dealers are shifting their thinking
by the Pope, who claimed that CDS was "gam- on the viability of trading the product, quickly
Hovnanian shouldn't be a surprise bling on the failure of others" seeing the prod- building and closing franchises. This pushes
While many of the managers which spoke to uct as simply a shorting tool. This ignores the market towards the biggest dealers, as
Alt Credit were frustrated that the case had the fact that many on the buy-side use the they remain the only constants, and bigger
raised fresh questions about the product, it product to go long; by definition, the nominal funds, as they're top of the list for new desks
didn't change their outlook on the product as value of CDS trades in existence is always a to gain as clients.
a whole. balance of long and shorts. "After Mifid II, Banks have been much less
Hovnanian was also a distressed debt situ- CDS therefore serves two purposes, firstly, willing to take on a new client to trade CDS
ation where reading the loan, bond and CDS to allow risk to be transferred to those most bilaterally unless they have a particularly big
documentation thoroughly, and fighting their able to bear it. Secondly, it also allows for a wallet," says Erlandsson.
cases in court, is par for the course. more liquid and rational market. "CDS cre-
"Accidents happen, and you don’t want to ates some price discovery," says Mill Hill's
be on the wrong side of something like Hov- Meneret. Credit markets are not nearly as Jon Close
Head of content, Alt Credit
nanian. But accidents happen in the bond liquid as equities, and price discovery can be
market too. Just think of SNS or BESPL," says very problematic. For example, many bonds
JUNE 2018
08 ANALYSIS
From big data to
alternative data:
finding an edge in credit investing
Alt Credit talks to managers and vendors taking advantage of the exponential
growth of data science techniques, and applying them to credit investments
By James Harvey
JUNE 2018
ANALYSIS 09
D
espite having become the such as misplaced decimal points in interest “When we were at RBS in 2005 and 2006,
subject of reams of buz- rates – before applying proprietary algorithms the bank had a technology budget that dwarfed
zword-laden drivel in recent to project future cashflows and value an MBS those of most hedge funds, but the simple fact
years, ‘big data’ is at heart a tranche. is that today’s processing power didn’t exist,”
simple concept. “10 years on from the financial crisis, ABS is he says. “Even as a two-person firm, we have
As computing power and still seen as a very risky asset class. But we can more computing power at our disposal than the
storage ability have increased, datasets have now use data science techniques to model cash- major banks did 10 years ago.”
become so large that traditional computational flows surprisingly accurately,” says Sciamma. O’Connor agrees with this assessment. “Data
tools are inadequate to process them. More One firm that has quietly built a presence analysis that used to take us 10 to 20 hours to
recently, the term has come to encompass in this area is Stamford, Connecticut-based run as MBS traders before the crisis can be fin-
analytical techniques applied to these datasets. data miner Webbs Hill, which is led by former ished in minutes today,” he says.
And, like the term itself, the principles behind RBS mortgage traders Scott Gimpel and Dan One New York-based structured credit trader
big data analytics are long established. O’Connor. Founded in 2014, the firm offers four told Alt Credit that his setup involves the use
In a recent letter to investors, London-based products with varying levels of historical data of up to 40 side-by-side CPUs, shortening data
credit investment firm WyeTree Asset Manage- on the non-agency RMBS market, including a processing times exponentially and allowing for
ment reflected on the founding of life insurer fully-managed data analytics platform based on widespread use of big data in RMBS trading.
Scottish Widows by Alexander Webster and Amazon Web Services’ Redshift database. At the same time, hedge fund compliance
Robert Wallace in 1744. The letter notes that And, perhaps following the example of the departments have become more comfortable
the pair, using Jacob Bernoulli’s ‘Law of Large MBS market, other areas of credit – notably the with cloud-based databases, rather than want-
Numbers’, were able to project death rates, growing peer-to-peer lending market – have ing to keep everything in-house.
required premiums, and their fund’s value over begun to move in a similar direction. “It has taken a while to get compliance
a 20-year period with a remarkable degree of
accuracy.
“It’s interesting to note that while other areas
of science have changed a lot over time, sta- The evolution of cloud computing,
tistics hasn’t changed much in principle,” says improvements in AI technology and the
Judith Sciamma, CIO at London-based Wye-
Tree Asset Management. “Instead, what has
continued growth of alternative data
changed is the magnitude of data available, and represent a massive opportunity for credit
the computing power available to process it.” investment strategies”
Big data has proven to be a very powerful
addition to credit hedge funds’ arsenals – par-
Andrew Eisen, IHS Markit
ticularly for managers investing in structured
credit. But, in keeping with Moore’s Law,
technological improvements mean it is a tool Eugene Lee, COO and CFO of marketplace departments to accept cloud computing, but we
that has now become very widely available – lending hedge fund startup Digital Mosaic are finding that more institutions are adopting
prompting credit managers to look further Capital, notes that most of the major peer-to- the technology now,” says Gimpel. “The simple
afield to gain an edge. peer lending platforms now make loan-level fact of the matter is that Microsoft, Amazon or
data directly available, meaning funds no longer Google’s cyber-security will always dwarf that
Big data in structured credit have to pay large sums for data from credit of financial services firms’ internal systems,
While complex credit instruments – such as reporting firms. since these are the firms attracting the best tech
MBS and ABS – have always been backed by “Access to big data in the lending space was talent right now.”
several thousand assets, it was not until the previously only possible for investors who could Gimpel adds that big data analytics platforms
aftermath of the financial crisis that loan-level afford several hundred thousand dollars per such as Amazon Web Services of Microsoft
information became widely available. year for an Equifax subscription – which ruled Azure do not store sensitive information about
In 2013, the Federal Housing Finance Agency out almost all smaller funds,” Lee explains. the funds themselves, making it easier to per-
directed Fannie Mae and Freddie Mac to begin And since 2013, firms including dv01, suade CCOs to sign off on cloud technology.
publishing loan-level data for agency mort- Orchard Platform and PeerIQ have offered cen- Of course, the increasing availability of big
gages, dating back to 1999. And in the years tralised analytics platforms allowing investors data techniques inevitably means that their
following the crisis, non-agency mortgage data to dig into whole loans and marketplace lending power will become increasingly limited. What
has also become more accessible. securitisations. used to be a competitive advantage for larger
Sciamma says investors can buy vast data sets funds is now a must-have tool in an increasingly
containing loan-level mortgage data, contain- Computing power, the cloud, and level playing field between funds.
ing millions of lines of static and dynamic data. compliance concerns While every fund now has specialist data
Static data includes zip, Fico scores at issu- While big data techniques have existed for some scientists trying to gain an extra sliver of advan-
ance, loan-to-value, and mortgage size, while time, it is only recently that they have become tage by refining their data-cleaning algorithms,
dynamic data tracks continuing information, accessible to typical credit hedge funds, rather for instance, the ultimate uses of loan-level data
such as whether the borrower has been paying, than remaining the preserve of large investment do not vary that much between firms.
or any modifications to the loan. banks. Webbs Hill’s Gimpel says that a key “Ultimately, most firms run a fairly standard
The challenge for investors is to clean these driver of this proliferation has been the rapid set of assumptions for modelling cashflows,”
vast data sets up – there is often a lot of noise, increase in computing power since the crisis. says O’Connor.
JUNE 2018
10 ANALYSIS
Big data market worldwide revenue forecast, 2011-2027 ($bn)
120
100
80
60
40
20
0
2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027
Source: Wikibon
The rise of alternative data official oil production and export figures,” he “The evolution of cloud computing, improve-
With this in mind, the question for credit man- says. “We can check very easily whether the ments in AI technology and the continued
agers becomes how to eke out that extra advan- country’s reported economic activity lines up growth of alternative data represent a massive
tage over competitors who already have access with records for key ports, and where those opportunity for credit investment strategies,”
to loan-level data. exports are actually going.” says IHS Markit’s Eisen.
Andrew Eisen, head of IHS Markit’s Enter- And it isn’t just investors making use of alter- And there are some obvious areas for poten-
prise Data Management (EDM) platform, says native data sources: marketplace lending origi- tial growth in the near future. While the US has
that the key battleground has therefore moved nators have got in on the game too, increasingly fully embraced the rise of big data, and there is
from simple big data to alternative data – which using data from social media as a gauge of a now extensive information available to credit
can be used either to generate alpha, or to find borrower’s creditworthiness. investors, gaps remain in other markets.
unique hedges for credit investments. “Leading originators, such as Kabbage, lever- In marked contrast to the American ABS
“With the sheer amount of data being created age social media data feeds including Facebook, market, WyeTree’s Sciamma says loan-level data
every year, there is necessarily a vast amount Twitter and Instagram, as part of their under- can still be hard to come by in Europe. Unlike in
that is completely new,” says Eisen. “Fund writing and fraud-detection policy,” says Lee. the US, it is not yet possible for credit managers
managers are having to carry out multi-factor And Eisen says machine learning and AI to buy large anonymous datasets containing
analyses on data simply to find out whether it’s tools like neural networks are being combined loan-level performance data – and mortgage
connected to their investments or not.” with expanding amounts of social media data servicer reports can be relatively limited.
For example, auto loan ABS investors now for input to drive credit risk decisions during “While it is possible to buy very large – and
have access to data forecasting the future value the origination process. “There is a long history accurate – data sets for MBS deals in the US,
of cars, forecasts for new models and produc- of investment in machine learning and data sci- the process is still in its infancy in Europe,” she
tion targets, and supply chain information for ence tools in fraud detection, and we’re seeing says. “Things are less systematic, and data is
car maintenance – none of which necessarily that base expand into ways to assess the like- collected from a number of different sources,
directly impacts the likelihood of existing bor- lihood that a borrower will be able to repay a which vary in presentation and quality.”
rowers repaying, but which may offer an insight loan. It’s very sophisticated AI,” he says. Lee echoes the same complaint for non-US
into future credit performance. Similarly, sat- marketplace lending originators. Digital
ellite images of shopping malls have become The future Mosaic, which launched earlier this year, has a
a way for credit investors to assess footfall at While the amount of data now available to 40% bucket for Asian loans and 15% for Latin
shopping malls, and therefore to take a view on credit hedge funds would have been unthink- America and Europe.
CMBS tranches backed by these credits. able in the pre-crisis era, the rise of big data “Outside the US, the infrastructure for big
More recently, investors have begun assess- and alternative data shows no signs of slowing data analytics isn’t established yet. We often
ing maritime data – including tracking goods down. According to data from Greenwich Asso- need to specify the exact fields we need from
entering and leaving ports, and GPS data track- ciates, US and European hedge funds currently originators operating in the emerging markets
ing ships around the world – as a way to check spend over $170bn per year for alternative data since loan-level or local credit bureau data feeds
official economic figures released by states, and – a figure that is only likely to increase as the have not been optimised for investor consump-
by extension, the credit risk associated with volume of available data increases. tion like they are in the US,” he says.
sovereign bonds. Eisen says data like this has Depending on the source, estimates suggest
proved invaluable to investors trading Venezue- that the amount of data is increasing by at least
la’s bonds and CDS. 60%-90% per year – and by 2020, the accumu- James Harvey
Reporter, Alt Credit
“Shipping and port data has been a very lated digital universe is expected to exceed 44
useful way to assess the veracity of Venezuela’s zettabytes (44 trillion gigabytes).
JUNE 2018ANALYSIS 11
MAY IN CLOS: “I am so bullish on the US economy right now,”
said Moore, highlighting the rise of the shale oil
industry in particular as a cause for celebration.
And most panelists expressed tempered opti-
mism about the state of the US economy, noting
that there are no short-term catalysts for a major
uptick in defaults. Moody’s expects the default rate
to decrease to 2% (from 3.6% in 2017), while S&P
Global is projecting a year-end default rate of 2.6%.
However, some managers expressed concern
about increasingly lax lending standards, and the
potential implications for CLOs.
Adjusted ebitda raises In a comment that highlighted the near uni-
versality of covenant-lite loans, Eagle Point’s
Tom Majewski noted that managers now view
eyebrows any fully-covenanted loan as “a problem credit
by definition”.
And Farboud Tavangar, a senior portfolio
manager at Tetragon’s LCM Asset Management,
Managers begin to express concern about increasingly lax noted that the typical CLO portfolio at issuance
is significantly riskier today than before the crisis.
lending standards “The average WARF for CLOs at issuance
By James Harvey stands at around 2700 today, compared with
W
2400 in 2007,” he said. According to Moody’s,
ith another $11bn of banks – the divide is deepening between those a 2700 WARF reflects an average portfolio rat-
US CLOs joining the who see the loan bull market as sustainable, and ing of B2, while 2400 reflects an average rating
market in May, things those who are worried about increasingly lax nearly a full notch higher.
appear – at least lending standards. Later, Tavangar took aim at the increasing use
on the surface – as Nowhere was this divide on more public dis- of adjusted ebitda figures in calculating leverage
healthy as ever. play than at IMN’s CLO and Leveraged Loan multiples.
With May’s figures – which included debut conference in New York last month, where econ- “Companies are being allowed to lever portions
CLO transactions from CarVal Investors, Kayne omists and CLO market participants discussed of ebitda that are totally speculative,” he said. “The
Anderson and Partners Group, $54bn of new US their outlooks for the US economy. adjustments that are being put in place are leading
deals have priced in the first five months of 2018 – During an energetic – and occasionally bizarre to true leverage levels that are significantly higher
46% higher than at the same point last year. – keynote speech, economist and CNN pundit than what meets the eye.”
Meanwhile, in Europe, four more CLOs Stephen Moore praised the impact of the current In a poll held during a later panel discussion
priced in May, taking issuance past the €10bn administration’s tax reform and deregulation on loan documents, 44.4% of respondents said
mark year-to-date and putting the market on policies, claiming that they would drive sustained that issuers hit their adjusted ebitda projections
course to eclipse 2017’s record of €20.5bn of full- 3% economic growth, slashing the federal govern- less than 50% of the time, with 55.6% saying that
year issuance. ment’s debt as a fraction of GDP. issuers hit their targets more often than not.
Overall, this means that $67bn of CLOs have
priced globally in 2018 – a 49% increase on the
first five months of 2017. The figure is also 26% Cumulative global new CLO issuance ($bn)
higher than the global total at the same point in
2014, which saw a record $143bn of combined US 80
z2014
and European CLO issuance (see chart). z2017
70
The flurry of CLO issuance prompted Wells z2018
Fargo’s CLO research desk to increase its full- 60
year issuance projection from $125bn to $150bn
towards the end of May. The bank’s analysts high- 50
lighted a relatively benign credit environment and
40
the end of risk retention as potential tailwinds for
issuance in the second half of the year. 30
However, while new issuance volumes stayed
high, refinancing and reset figures declined from 20
the previous month. Since most CLOs follow a
January-April-July-October payment schedule, 10
refi volumes tend to dip in the second and third
0
months of each quarter. Jan Feb Mar Apr May
But, while everything is currently rosy – par- Source: ACI, Wells Fargo
ticularly for the CLO arranging desks at major
JUNE 201812 ANALYSIS
May in CDS:
The good, the bad, and the ugly?
Italian fears spark rout in CDS, as legitimacy comes into question
by Jon Close
I
t was quite a month for the derivatives ued to make headlines. First there was talking of
market. Volatility has definitely inched both Solus and GSO essentially trying to squeeze
up across the board for credit in general each other out of the trade, before it emerged that Major CDS indices (bps)
and dispersion has been steadily growing Goldman Sachs had sold out of its positions at Spread, 1 June 1-month
among credits since February. least partially to appease a major client. But then, Index 2018 (bps) change
But events in Italy took things to a seemingly out of the blue, the Solus and GSO CDX NA IG 67 6
new level. The two biggest populist parties in the came to an agreement, and the deal was settled.
countries agreed to form a coalition after weeks Akshay Shah, the man behind the trade, and CDX NA HY 353 14
of wrangling. similar trades at GSO was profiled in the press as iTraxx Main 70 16
There was a problem with their chosen finance a scourge of trading desks and rivals, an aggres-
iTraxx Xover 307 37
minister, who had quite hilariously lied on his sive trader who made a habit of these kinds of
CV, but more importantly had pledged to leave deals. He recently left GSO, and has since reg- iTraxx Sen Fin 87 29
the euro without further public consultation. As istered the firm name Kyma Capital in London. iTraxx Sub Fin 196 75
both parties had campaigned saying they were Hellebore’s DataGrapple service highlighted
Source: IHS Markit, Deutsche Bank
committed to the euro, the president rejected another trade which slipped under the radar, as
their request to form a government with him in Sears’ largest shareholder ESL Investment asked
the seat. A few days of panic ensued, with talks the firm to sell businesses to ESL. Sears would Despite all the action, almost all major indices
of a technocratic government, until a new candi- then pay down some of its most distressed bonds, ended the month a shade wider, as the Italian
date was put forward and accepted. reducing the value of any CDS contracts. It’s government managed to form with a finance
There were talks that the ECB had intention- not clear if ESL had sold any CDS protection on minister palatable to the markets just before the
ally tweaked its bond buying program to accen- Sears, but perhaps it should’ve done. month was out.
tuate the issue, but CDS markets suggest the fear
was real, and bond maturity schedules suggest
the shift in purchases was legitimate too.
CDS indices blew out on the back of the news, Volatility has definitely inched up across the
and the fears spread to the US into the end of the board for credit in general and dispersion has
month. As Alt Credit goes to press however, a
new government has been formed, and spreads been steadily growing among credits”
have shot back down again.
A stark reminder that credit traders can’t
afford to sell in May and go away in this climate. The pope wouldn’t have to look far for his next Through mid-month, the CDX EM index had
CDS story though, as Italian spreads blew up in been suspiciously unmoveable. In fact, on the
Creditbility swaps the wake of a populist government that briefly day before options expiry, with a host of issues
Attentions were piqued by a number of other CDS looked likely to threaten Italy’s place in the euro. building for emerging market credit, the index
headlines in May. Firstly, the Pope chimed in, lam- As mentioned on page four, this opened up the was reportedly ‘stuck’ just under 55bps. It was
basting the CDS market it as ethically inexcusable. ‘Isda basis’ even if its effects were over blown. said that a lot of ‘pin’ risk had built up, and the
There were rumours of an attempted personal Experts reckoned it was more likely to affect Ital- 55bps strike had been popular with options
Isda agreement application failing, while these ian corporates. buyers. The index itself is illiquid enough that
are so far completely unproven, the document It was actually Deutsche Bank that ended up it wouldn’t take much effort for a company to
released by the Vatican seemed to contain a fair bearing much of the brunt however, as questions defend that position.
degree of sophisticated knowledge about the over its Italian exposures merged seamlessly
market, appearing to favour central clearing. with the FDIC questioning the viability of its US
The timing of the criticism was actually prob- business. The firm’s senior spreads jumped out Jon Close
Head of content, Alt Credit
ably more to do with the then-ongoing saga over 35bps to 190bps on the last day of the month as
Hovnanian. The New Jersey homebuilder contin- its shares tumbled.
JUNE 2018DISCOVER
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SALES LEADS
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GAIN A
C O M P ET I T I V E
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hfm.global/data14 COMMENT
LIFE AFTER LIBOR
The Federal Reserve began publishing its replacement to Libor in April, as markets
undertake the process of transitioning structured credit, bank loan and derivatives
instruments away from the legacy interest rate that had been tarred by unlawful
collusion. DealVector’s Dave Jefferds and Michele Kelsey of International Solutions
Network believe that technology may provide the key to achieving this result for
securitised products
JUNE 2018COMMENT 15
T
he Libor reference rate is have also been pushes in the US, through regula- pass maturity extensions on $18bn of issuances
written into the contracts of tions like Reg AB II, investor based trade associa- with 100% consents thresholds! The last involved
approximately $370trn global tions, (SFIG RMBS 3.0) and industry groups that position sizes from $25,000 to $200m or more
transactions, including secu- call for similar communication. across almost 400 investors.
ritizations like CLOs which And the call for increased communication Clearly, communication technology is benefi-
comprise approximately $10trn is not only coming from regulators and rating cial to an orderly market, and policymakers have
of the total. After a string of scandals that made agencies; it is also coming from investors, trade recognized this fact, particularly in Europe. But
a change necessary, markets are beginning associations, and other market participants. there is more to be done, since the basic settle-
the gargantuan task of moving away from the These create operational and compliance ment infrastructure of finance makes it very
benchmark. requirements globally for both buy side and sell difficult for investors to coordinate.
The key question for each outstanding instru- side players, trustees, servicers brokers, and all The possibilities of an improved communica-
ment is: what will the new reference be? It may other parties in the transaction chain. In the US, tion system would be exciting and likely lead to
be the benchmarks with existing history and regulations like Reg AB II, investor-based trade more business for everyone. The volume of new
depth like SOFR will become the default for associations, (SFIG RMBS 3.0) and industry issuance, it is believed, could increase as confi-
many markets. But while derivative contracts are groups are all calling for similar communication. dence of investors improved.
likely to receive globally standardized treatment
from ISDA, securitized cash transactions are What type of communication: Further benefits:
not homogenous. Consequently, holders must With the forthcoming move away from Libor The potential to leverage better communications
review the critical language found in each trust on top of the regulatory and investor-mandated technology will have a meaningful impact on
document. Then each trust will need to “decide.” initiatives, communication amongst all parties liquidity, which will lead to better mark-to-mar-
In some cases the transition from the LIBOR that is authenticated, identity-protected, and that ket pricing and a positive impact on risk retention
benchmark is contemplated in the language and makes use of voting, tabulation, and corporate capital requirements. Ultimately the goal is to
may be a smooth process. In others the process actions tools will not only be beneficial; it will be maintain market confidence and retain inves-
may not be smooth. And in other indentures the mission-critical to fulfilling these requirements. tors when conditions change. This increase in
transition may not be contemplated at all.
Moreover, different participants to the trans-
action may not be aligned, and the economic
consequences might be significant. For example,
Any good active manager will have
in CLOs if the collateral in the asset side of the cherry-picked the best of the universe for
trust resets to one benchmark while the tranche their clients’ portfolios, minimising”
liabilities reset to another, the equity might
receive either a windfall or a catastrophe.
Securitized markets including CLOs are noto-
riously illiquid, further exacerbating the risks. It The process of finding all the interested par- liquidity and resultant positive impact on credit
may be that even if parties are aligned to pursue a ties and negotiating a switch (to a new reference will ultimately help lower capital requirements
particular adjustment to the indenture language, in the case of Libor, or generally with respect and create a securitised market environment that
the necessary votes to amend cannot be found! to any amendment) could be time consuming is supportive of growth and recovery.
This result would echo some of the challenges and laborious without the communication tools Another benefit of these technological solu-
that occurred following the 2008 crisis. Typically DealVector has implementing, particularly tions in aggregate is they will create a better mar-
in structured credit transactions less than 10% of through its Liborhub module. Liborhub connects ket and allow for better pricing and valuation.
the holders can be identified easily from public into DealVector’s network of over 1000 institu- With increased communication, and therefore
sources. By contrast, almost half of holders of the tions that participate in the structured credit transparency and liquidity, valuation services
debt of the Fortune 500 can be found, and public space, consolidates market information, and will have access to more actual trade data, allow-
holders of the Fortune 500 equity can be found in provides communication and voting facilitation ing them to provide the highest quality prices. A
approximately 85% of cases. tools to make it easier for participants to manage better system for communicating axe sheets and
Therefore, for approximately $10trn of struc- their risk. DealVector can review documents for quotes will support trade decision analyses, as
tured credit transactions globally (including clients as well as analyze market holdings and well as end of period valuations and modelling.
CDO, CLO, RMBS, CMBS, and Syndicated estimate the difficulty of execution for parties Intra-day and end-of-day pricing will become
loans), the stakes are high and the solutions that are concerned about their transactions. more robust, more accurate, have less volatility
appear to be difficult to implement. The benefits of this type of market communi- and will help meet audit requirements for addi-
It’s not only Libor: cation have already begun to accrue. There are tional marks.
An array of regulatory requirements that have numerous specific examples where firms were
unfolded in Europe and the US since the financial able to locate and communicate with their (previ-
crisis have all shared a common objective: restor- ously unlocatable) end investors, secure and tab- Dave Lefferds
Co-founder, interim CEO
ing confidence in the European financial and ulate needed approvals, and provide corporate DealVector
securitisation markets, through tighter controls actions and other documentation. On DealVec-
and communication, increased transparency and tor, for example, managers were able to ‘Volck-
information sharing across all parties. erise’ their CLO transactions, community banks
Michele Kelsy
STS, Solvency II, IFRS 9, Basel III and MiFID were able to locate their TRuPS liability holders Managing director
II are all scheduled to take effect in the next 15 to effect recapitalizations, and the entire Student International Solutions Network
months or have already been implemented. There Loan ABS investor universe came together to
JUNE 201816 COMMENT
GETTING USED TO
EXPECTING THE
UNEXPECTED
As the Fed pulls back from quantitative easing, benign, but investors may be getting used to
expecting the unexpected.
credit markets will have to get used to more frequent
bouts of volatility, says BlueBay’s head of credit strategy, Beginning of the end for beta cruising
20 September 2017 marked a watershed
David Riley moment for global financial markets – the
beginning of the end of quantitative easing
T
(QE). The world’s most influential central bank
he QE investment regime that greater asset price dispersion, lower correlations – the US Federal Reserve (Fed) – announced
inflated asset prices by supress- and increased event risk. that from October it would start to shrink its
ing dispersion is coming to an In assessing financial markets in 2018, balance sheet, bloated by more than $4.2trn
end. The Fed is shrinking its we have already witnessed several bouts of of Treasury and mortgage-backed securities
balance sheet (also known as volatility, beginning with the record move amassed since the 2007–08 financial crisis in
quantitative tightening) and in Vix index in February, followed by subse- an effort to forestall a depression and stimu-
the ECB (and BoJ less transparently) is tapering quent spikes in Argentine, Turkish and more late economic recovery.
its asset purchases. recently, Italian assets. One wonders where The European Central Bank (ECB) and Bank
Markets are past ‘peak QE’ and even though there is currently complacency in markets of Japan (BoJ) are also gradually reducing the
central banks’ disengagement is gradual, it and where a shock could show up next. scale of their asset purchases. The peak in QE
nonetheless marks a profound shift in the However, the global growth dynamic is still has passed with important implications for
post-crisis investment regime, marked by constructive, and policy remains broadly asset markets and investment strategies.
JUNE 2018COMMENT 17
QE and the investment regime For the past few years as developed market gov- Greater political and policy uncertainty
The wash of stimulus money that flooded mar- ernment debt has yielded so little, high yield and requires investors to have access to a broader
kets from 2007 suppressed asset price disper- non-investment grade bonds have done well. range of intelligence sources. These include the
sion and elevated cross-asset correlations as the Investors have chased yields into more risky need for proprietary research through direct
ebb and flow of central bank liquidity became areas of the fixed income market, accepting communication with key influencers, recog-
the overwhelming common macro factor higher levels of default in anticipation of higher nising and exploiting news bias and effectively
driving global asset prices. Correlations across returns. While we believe there are attractive utilising social media. The rise of unreliable
sectors within asset classes and between the investments across the asset class spectrum, news sources and ‘fake news’ means that inves-
individual asset classes themselves rose along subscriptions for high yield and non-investment tors have to be smarter and selective in what
with markets. Yields were pushed artificially grade bond issues have risen, influenced by they consume.
low, valuations moved upward and the classic somewhat inflated issuer company valuations.
negatively correlated relationship between Fortunately, in line with falling correlation Not so safe – traditional debt now
bonds and equities became distorted. In such levels, we are starting to see greater differentia- vulnerable
an environment, the rewards from asset and tion within sectors. This should pave the way for The purpose of traditional core fixed income
security selections were much more limited active managers to put their selection powers – high grade and government bonds – in
with investment returns dominated by the QE to work, scrutinising underlying fundamentals many investor portfolios is to provide pre-
induced ‘beta’ rally that favoured passive bench- to select the best quality positions, rather than dictable income and safety, including low lev-
mark-tracking over active investment strategies. any issuer doing well on a combination of hype, els of asset price volatility. The legacy of QE
But as the QE-era investment regime overblown equity prices and guaranteed market and ultra-low policy interest rates is that tra-
begins to unwind we are witnessing the first security as QE flows were indiscriminate in the ditional fixed income offers very little in the
signs of a shift in the investment environment. companies they ultimately supported. To para- way of income and is increasingly vulnerable
Stock correlations across the S&P 500 index phrase Mario Draghi, central banks did ‘what- to episodes of market volatility. The interest
fell throughout 2017 and dispersion in stock ever it took’ to bolster markets. One result was rate sensitivity of fixed income benchmarks
performance is rising, helping active equity very low dispersion. As this support is now being – their duration – has increased dramatically
managers to outperform passive investment withdrawn, we expect dispersion to increase. during the QE-era.
vehicles. Similarly, dispersion in credit, espe-
cially in high yield, is also moving higher as
investors recognise greater differentiation in
borrowers’ credit profiles.
Any good active manager will have
cherry-picked the best of the universe
Three post-QE shifts for their clients’ portfolios, minimising
1. Lower asset correlation
Asset correlations measure how investments
downside exposure”
move in relation to one another. For much of
the post-crisis period, markets moved in lock-
step, signalling high correlation. This defies 3. Lower beta (market) returns With duration levels at record highs, many
classical financial theory, which tells us that QE flows supported markets and drove up traditional holdings have become portfolio dead
when equities rise then bonds should fall, and performance through the two factors discussed weights: they offer record low yields (negative in
vice versa. Instead in the QE-era there was often above. As the global bulk bond buying cam- some cases including Germany, Switzerland and
a positive relationship between the two. Look- paign is unwound, overall market performance Japan) and will be hit hard by higher interest
ing within the fixed income universe, regional (market beta) will likely ease off, reflecting the rates and volatility. In the space of just six weeks
differences in the performance of government fact that post-crisis return levels have been held from end April 2015, a mere 50 basis points rise
bonds and credit have become less pronounced artificially high. Declining market values will in German bund yields led to a negative return
as the ebb and flow of central bank liquidity likely cause alarm for investors following broad- of more than 6% for investors passively holding
has overwhelmed divergences in economic brush passive approaches, as they hold all index a portfolio of German government bonds.
and credit fundamentals. While this ‘rising tide constituents indiscriminately and are therefore
lifts all boats’ environment benefited passive exposed to all of the downside. But any good The QT highway
index tracking strategies, active managers were active manager will have cherry-picked the best The episodes of volatility so far this year are a
thwarted as low-quality companies followed of the universe for their clients’ portfolios, min- reminder of the post-QE investment regime
markets upwards without the fundamentals to imising downside exposure. Lower beta returns which is marked by heightened volatility and
back their inflated valuations. However, we are lead the way for true alpha generation, where a more challenging technical environment.
now seeing early signs that correlation levels are manager performance is ahead of the market as Greater cross-asset dispersion as well as vola-
beginning to ease, with the 2017 numbers simi- a result of intelligent issuer selection. tility will likely persist. Nonetheless, more bal-
lar to thosew recorded pre-2008. We expect this anced investor positioning as well as evidence
shift to continue as QE is withdrawn. Political noise & activist policies that global growth remains well above trend
One factor driving the increase in dispersion is the provides some comfort.
2. Greater dispersion in asset performance rise of populist politics and more interventionist
Falling correlation levels provide a proxy for governments, a trend we expect to continue as
David Riley
increased dispersion. Essentially measuring the central banks wind down QE. Voter allegiances Head of credit strategy
difference between the best and worst perform- have become more fluid, rendering traditional BlueBay
ers in any group – in this context asset classes. sources of political insight less reliable.
JUNE 2018You can also read
