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Pound for pound: Demand for sterling CLO tranches is picking up

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Until recently, collateralized loan obligations denominated in pounds sterling were a tough sell.

European CLO managers have long expressed an interest in issuing sterling tranches of notes, if only because this would make it easier to find enough assets for deals. The alternative – issuing euro denominated notes backed by assets denominated in pounds – requires hedging against changes in exchange rates, which is expensive. But there just weren’t enough buyers for sterling notes to make issuing them, and saving on hedging expenses, worthwhile.

That appears to be changing. In July, PGIM launched a £325 million deal, dubbed Dryden 63 GBP CLO that is the first pound-sterling CLO that S&P Global Ratings has rated in five years. All of the notes being offered are denominated in pounds, as are the loans and bonds used as collateral. (Assets denominated in other currencies may be added in the future, however.)

Also in July, Barclays launched Sirius Funding, a CLO that will issue securities denominated in three different currencies, pounds and euros and dollars, totaling £4.5 billion. The notes are backed by assets in all three currencies. It is the first pound CLO that Moody’s Investors Service has rated since 2014.

Interestingly, demand for the pound CLO securities comes primarily from Asian investors, not U.K. investors, according to Aidan Canny, a managing director in BNY Mellon’s corporate trust business in Europe, the Middle East and Asia.

Asian investors are the largest purchasers of CLO paper in the European market, and Canny said that many of them are looking to diversify their portfolios by buying assets denominated in different currencies. “There is obviously a significant amount of pension funds, insurance companies and banks that purchase this type of paper, and I think it’s just currency diversification strategies,” he said.

These strategies could be based on a long-term view of U.K. macroeconomic fundamental or potential concerns over how Brexit may impact pound- or euro-denominated securities.

Of course, pound-denominated CLO notes could also appeal to U.K. investors, who would not need to worry about foreign exchange risk, as the do with euro-denominated CLOs. However, it seems that this natural buyer base was not large enough to justify issuing sterling notes.

Multicurrency deals themselves are unusual, those with a pound tranche even more so. The vast majority of outstanding deals have notes denominated in either dollars or euros, and the circa 160 CLOs totaling $87.9 billion are nearly six times the size of the 45 euro CLOS totaling €22.56 billion.

Multicurrency CLOs were more common before the financial crisis, and were commonly backed by loans and bonds denominated in both pounds and euros. Hedging was unnecessary since pound-denominated CLO securities were backed by pound-denominated loans and bonds, while euro-denominated CLO securities were backed by euro-denominated loans and bonds.

That’s the strategy Barclays is using with Sirius Funding, which is issuing three tranches of notes in three difference currencies that all carry the same Aaa credit ratings. The pound notes are backed by pound assets, the euro notes are backed by euro assets, and the dollar notes are backed by dollar assets. However, should one or two tranches of the tranches be redeemed early, the principal and interest proceeds from the corresponding currency will be converted to pay off the remaining tranche(s).

The euro and dollar tranches issued by Sirius were sized to match with their GBP equivalent of £1.125 billion; there is also a subordinate tranche of notes denominated in pounds that will be retained by Barclays.

Sirius priced in early August; each tranche of notes pays 140 basis points over the appropriate interbank lending benchmark (Euribor , the pound Libor and dollar Libor).

For now, Dryden 63 GBP CLO does not need to be hedged, since both assets and liabilities are denominated in pounds.

It is the only one of 12 CLOs actively managed by PGIM, the principal asset management business of Prudential Financial that is not denominated in Euros. The £171 million senior tranche of notes, which is rated AAA, pays 125 basis points over three-month or six-month Libor. The deal, which was arranged by NatWest, is expected to close in September.

The European CLO market has been brisk in 2018, with near doubling of new issuance to €17.8 billion through the end of July, and a 15% growth this year in outstanding European CLO volume to €86 billion, according to Thomson Reuters LPC. By comparison, the much larger U.S market, which is on pace for a record year of issuance at $78 billion through July 31, has seen a 10% growth in outstanding volume to $547 billion in the same time period.

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CLOs CDOs Barclays Europe European Union U.K.
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