Where do fixed income investors go from here?
The macroeconomic headwinds that have pummelled all asset classes this year finally spilled over into the European ABS and CLO markets in the second quarter, creating a large amount of volatility.
Spreads have been pushed markedly wider, but this has been down to the deterioration in general market sentiment rather than any credit concerns on behalf of investors. Of course, the floating rate nature of European ABS and CLOs means they are not negatively impacted directly by rates moves, in fact they benefit from tightening central bank policy as bond coupons rise in line with rate rises.
However, this did not prevent relentless selling from investors facing redemptions, and with dealers not being in a position to use balance sheet to provide much needed liquidity, this added to the volatility. The only positive note from ABS and CLO trading in Q2 was that a substantial amount of paper changed hands, though this liquidity didn’t come cheap.
One of the reasons for the selling is that ABS typically sits within global credit funds, forcing asset managers to reposition their portfolios due to outflows from their global strategies. UK pension funds have also been heavy sellers, as their formulaic approach forces them to buy Gilts and reduce credit. As we entered this period of high volatility, leverage within the hedge fund industry was lower than at the beginning of the COVID-19 crisis and we’ve seen less selling from hedge funds hitting margin calls as a result. In fact, hedge funds (and private equity) have been reported as the main buyers of mezzanine CLO bonds in recent weeks.
Total volume on Bids Wanted in Competition lists (BWICs), an auction process run by investors to sell bonds, reached $6.8bn in Q2, well above the quarterly average of $5.2bn in 2021. The majority of this activity was concentrated in May, and was dominated by CLOs (55% of volume) and AAA RMBS, a fair representation of the composition of the European ABS market.
Once again, investment banks currently have limited risk appetite to put their balance sheets to work holding bonds for trading, and while some have bid back on the BWIC lists, sellers are heavily relying on other market participants to provide liquidity. This is generally achieved through BWIC processes, offering client-to-client liquidity (circumventing the banks), and this has generally resulted in the best and most transparent liquidity we have seen so far this year. For example, we’ve seen a resurgence of bank treasuries buying UK non-prime AAA RMBS.
The large buyers of AAA CLOs in the primary market are typically insurers and bank treasuries, both of whom favour certainty of execution over spread level and are not active in the secondary market in small sizes. This leaves sellers more exposed to dealers’ bids which have dropped rapidly lower in line with the greater BWIC volume. Therefore, we are currently seeing a dislocation between AAA CLO notes being priced at par with a coupon of 3mE+160bp in the primary market, and secondary market spreads at 3mE+195-215bp with cash prices around 94-96. It is hard to understand why anyone would buy AAAs at that level in primary, when yields of almost 4% (in euros) and that degree of convexity is available in the secondary market.
We have been positively surprised by the depth of the BB CLO market in particular, which has been well supported by US investors, hedge funds and private equity buyers as European CLO BBs currently offer better relative value than their US counterparts (with less leverage), which have historically traded wider. But liquidity has been expensive as these investors don’t buy at 7% yield, and as a consequence BBs are now trading at 12-13% yield in euros at cash prices of 70-80, as a great deal of performance tiering and spread duration is visible. Meanwhile, the supply of mezzanine bonds in RMBS, Consumer ABS and Auto ABS has been more limited, but bids have also dropped significantly.
Liquidity has been expensive across European ABS and CLOs as dealers have pulled back their bids and investors have been active opportunistically, with the result being that bid-offer spreads have widened to at least 1pt on AAAs and 2-4pts on BBB to single-B rated bonds. If there is a positive note here then it is that despite the spread widening and increased cost of trading, we have seen a healthy volume of bonds moving both ways, which was not the case at the peak of the COVID-19 crisis in early 2020.
The use of BWICs in the ABS and CLO markets not only gives investors a great deal of insight in terms market depth and pricing colour, but it also creates a great opportunity to pick up bonds at yields and prices that we haven’t seen since Europe’s sovereign debt crisis.