Another way CLO managers profited from 4Q loan selloff: Par build

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A sharp but temporary drop in December loan prices allowed a handful of CLO managers to “print and sprint” new-issue collateralized loan obligations by scooping up bargain assets.

But a new research report from Nomura shows managers were perhaps even more prolific in using the short-term discount window. Based on January trustee reports, according to Nomura, managers of broadly syndicated CLOs took advantage of cheap-and-healthy loans that improved the value of several existing deals.

According to Nomura, more than 50% of CLO managers used low-bid priced loans from the secondary market in the fourth quarter to "build par," an exercise in acquiring lower-cost assets that still count as par assets at full face value that help meet collateralization level requirements.

Nomura estimates "around 25% of managers built par of at least 5 [basis points] ... primarily via secondary market trades."

On the flip side of the coin, the remaining managers lost par in selling off distressed assets at discounts during the volatile loan-pricing period. That meant while more managers gained par, the half that didn't saw deeper cuts to their par levels because of the steep drop in secondary market prices.

Nomura said the range of par build (negative to positive) for CLOs expanded to an array of (-)11 basis points to (+) 6 basis points array in the fourth quarter from the tighter (-6) basis points to (+)4 basis points in the third quarter.

"With increased loan market volatility in 2018Q4, the dispersion in par build has increased based on manager trading activity in this time period," the report stated.

Par build, or the difference in held value vs. book value of loan assets, is used to determine the total principal balance of collateral for the deal, which in turn helps calculate the overcollateralization amount against the lower principal balance of outstanding notes issued through the CLO.

By buying and trading into lower-cost but higher-rated assets, CLO managers can usually build cushions on a number of asset-quality and portfolio valuation tests serving as protection for note investors. Since CLOs are non-“mark-to-market” investment vehicles, managers value their portfolios at the book-value price of loans rather than current trade bid levels.

Overcollateralization is an important test applied at different levels to each tranche of notes (with higher OC for senior notes) to ensure the deal's obligor payment waterfall will satisfy the principal and interest needs of the notes. Triggering an OC test failure means principal and interest is diverted from equity (or ownership) payment flows and subordinate tranches to meet the coupon obligations of senior notes, beginning with the triple-A bonds.

If a manager uses available cash equal to 5% of a deal's total principal balance, for example, a 2% discount on a loan's coupon price would yield a 10 basis point gain in par build.

The prime sources of par build in CLOs were in secondary loan trades involving 2017 and 2018 vintage CLOs, according to Nomura. Greywolf Capital Management (0.5%) and Black Diamond Capital Management (0.2%) achieved the highest gains.

Some managers also used the low-price opportunities to swap out riskier single-B rated loans for higher-rated assets, often trading at similarly discount prices. Nomura said those managers included Brigade Capital Management, THL Credit Advisors and Octagon Credit Investors.

Loan market price drops occurred throughout the fourth quarter, but peaked in December when mutual and loan-fund investors sold off $12.6 billion in leveraged loans, and prices plummeted on nearly all trades regardless of credit quality.

Loan price bids dropped to a low of 93.84 cents on the dollar, according to data from the Loan Syndications & Trading Association, and 97% of loans had “mark to market” price drops – most by more than 100 basis points.

Loan prices recovered in January, with average bids at 95.81 cents at the end of the month.

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