Signs Of The Top? Chinese Demand For 10x Levered Structured Products Surges In US... Again

In the run up to the "great recession" of 2008/2009, it was unsuspecting European and Asian buyers that supplied the marginal capital required to turn America"s plain vanilla, fed-induced housing bubble into a turbo-charged, global financial time bomb by indiscriminately scooping up highly-levered structured mortgage products with absolutely no idea what was behind those products.

Now, it seems that China"s lust for levered returns in U.S. structured products has returned and is focused this time around on the CLO market.  Per Bloomberg: 

Now, a new set of buyers from China are hoping things turn out differently. Instead of snapping up packages of risky derivatives tied to U.S. home loans, they’re buying collateralized loan obligations that bundle together corporate loans to highly leveraged companies. And while such CLOs weathered the last crisis relatively well, there’s already concern that these investors are being tempted to deploy leverage to amplify their returns.

 

On a recent trip to China, potential new investors expressed interest in the idea of applying leverage for the purchase of CLOs, even at the riskier BB level, Chan said. He estimates levered returns for the BB-rated CLO slice may be almost 20 percent. Leverage is employed using the repo financing market, where short-term loans allow investors to borrow money by lending securities.

 

"Over the last 18 months, Chinese investors have shown a marked increase in interest, awareness, and desire to be educated about CLOs, and they’re a pretty sophisticated audience,” said John Popp, global head and chief investment officer of the Credit Investments Group at Credit Suisse Asset Management. The company has $46 billion in assets under management, including CLOs that have a market value of $18.3 billion.

 

“They’ve really learned the product quickly and engage in extensive due diligence,” Popp said. “I expect to see them as steady and growing participants in the CLO market, not as tourists.”

Even though Chinese investors have yet to enter the CLO market en masse, Mitsubishi UFJ believes they could effectively double the demand for CLO new issues in a matter of just 5 years.

In some cases, investment banks and CLO managers have made as many as five trips to Asia this year, adding on special CLO-focused investor conferences in mainland China for the first time ever to raise the product’s profile. The demand to diversify into dollar assets has grown from a wide range of investors, despite Chinese-government capital controls limiting deployment of capital abroad.

 

While Japanese, Korean, Singaporean and Taiwanese investors have been buyers of U.S. CLOs for many years -- even pre-crisis deals, in the case of Japan and Korea -- mainland China is still a relatively nascent, untapped market.

 

“Mainland China is the last market for us to focus on, and we’ve been there four times already this year,” CIFC’s Wriedt said.

 

In contrast to other Asian investors, the Chinese are more willing to invest deeper down the capital structure, or even in the riskiest equity piece.

 

The Chinese investor base for CLOs may be equal to the U.S. in five years’ time if capital controls are relaxed, MUFG’s Khan said. More than $106 billion of new U.S. CLOs have priced so far this year, and the vast majority of investors are still U.S.-based. Potential Chinese investors include quasi-sovereign or insurance companies, so "even a small percentage of what they will do will lead to a large capital infusion," Khan said.

Of course, not everyone is convinced that investing in 10x levered structured products is such a great idea with yields on highly-levered bank debt hovering around all-time lows...

“It wouldn’t be wise for the Chinese to use leverage at this stage,”
said Asif Khan, head of CLO origination and distribution at MUFG. “It’s

dangerous territory. Leveraging BB-rated bonds - is that a good idea?

Any potential use of leverage by Chinese investors could pose potential

risk in case of severe volatility.”

...but what"s the worst that can happen?  It"s not as if Lehman Brothers can liquidate again...

Structured Credit Bubble 2.0: Asian Investors Binge On "Boom-And-Bust" CLOs; Issuance Up 97% YoY

Back in 2006, some of the wall street banks (ahem, Goldman) managed to layoff quite a bit of their mortgage risk to unwitting European and Asian investors who, in their desperate "search for yield", had no idea they had just been conned into stepping in front of a freight train.  Now, it seems that the same thing may be happening yet again with another favorite wall street structured product, Collateralized Loan Obligations (CLOs).

According to Bloomberg, money managers in Korea, Japan and China are piling into CLOs, and often into the most junior tranches no less, at an alarming rate which has resulted in a staggering 97% increase in YoY new issuance volume.

Faced with near record-low interest rates at home, money managers in Korea, Japan and China have been piling into complex and increasingly risky structured loan products in America. Their investments in collateralized loan obligations -- including the high-yield “equity’’ tranches most exposed to defaults -- have helped drive a doubling of issuance in 2017.

The bets have performed well so far. But some observers worry that Asian buyers are overlooking risks. Headwinds in the retail and energy sectors have raised the specter of defaults, while Moody’s Investors Service has stopped evaluating one type of CLO product amid concern that buyers will end up holding less creditworthy positions than they anticipated.

“CLOs are a difficult investment universe, and CLO equity is a boom-and-bust product,’’ said Mike Terwilliger, a New York-based portfolio manager at Resource America Inc., which oversees more than $9 billion and invests in CLOs. “Investors need to make sure they’re being adequately compensated.’’

“U.S. CLO equity is starting to look a little less attractive,” Tyler said. “Investors may want to lighten up on this space before there’s a turn in the credit cycle given the illiquid nature of CLO structures.”

Meanwhile, non-U.S. money managers’ share of American CLO tranches with single-A credit ratings more than tripled to 21% last year, mostly due to surging demand from Asia, according to Citigroup Inc.

Korea Post, which manages about $102 billion of savings and insurance products, said in March it had been adding to CLO holdings. Japan Post Bank Co. has made plans to boost exposure to the safest tranches, people familiar with the matter said in January. Gopher Asset Management, a Chinese investment firm that oversees $17.5 billion, is currently raising money for a second global credit fund that may invest in CLOs, said Chief Investment Officer PV Wang.

Some “super-aggressive’’ Korean funds are buying equity tranches, according to Eugene Chun, who helps manage about $100 million of CLOs as a Seoul-based executive managing director at HDC Asset Management. Others are purchasing what’s known as combination notes, Chun said. The products blend investment grade and equity tranches to deliver higher yields while still maintaining adequate credit ratings.

Helped by strong Asian demand, CLO issuance has totaled about $32 billion so far this year, up 97% from the same period in 2016, according to data compiled by Bloomberg.

Of course, the reasoning is fairly simple and quite familiar for those of us who lived through the "great recession".  With all-in yields on even the riskiest U.S. debt hovering at just over 5.5%, much lower than even the 2006/2007 bubble levels...

...wall street has a convenient product that takes "safe" levered loans, packages them up in a nice little bundle and then sells them to folks all over the world with juicy yields and an investment grade rating.  It"s a win-win-win...lower risk, higher yield and IG rating...

Haven"t we seen this movie before?

Decade-High $100 Billion Of Corporate Loans Refinanced In January As Companies Prepare For Higher Rates

Anyone who slipped into a coma 10 years ago and suddenly woke up today, may come to the erroneous conclusion that not much had happened in U.S. debt and equity markets over the past decade.  Like in 2007, equity markets seem to surge to all new highs with each passing day, corporate credit spreads have tightened to 10-year lows and leveraged loan refinancings are soaring as all the "money on the sidelines" just can"t seem to find a home fast enough. 

As the Wall Street Journal noted today, the fear of rising interest rates, which have so far largely been offset by tightening spreads for corporate levered loan borrowers, has sparked a massive wave of corporate loan refinancings, including $100 billion worth of volume in January 2017 alone.  Moreover, per data from LevFin Insights, $222 billion, or nearly 25% of the entire leveraged loan market, has been refinanced since October.

Rising interest-rate expectations are fueling the biggest corporate-refinancing boom in years.

U.S. companies refinanced $100 billion of loans in January, the largest monthly total in at least a decade, according to data from S&P Global Inc. More than 110 low-rated companies, including software giant Dell Technologies Inc. and car-repair chain Service King Collision Repair Centers Inc., have refinanced loans since October, according to data from LevFin Insights LLC.

Borrowers in recent months have saved more than $1 billion in annual interest costs by renegotiating terms with their lenders, according to a Wall Street Journal analysis of the data.

Total repricings since the start of October amount to $222 billion, representing 24% of all outstanding leveraged loans, according to LevFin Insights. Firms negotiated an average interest reduction of 0.59 percentage point.

Of course, rising interest rates, which are feared to continue pushing higher, are sparking this latest refinancing bubble...

...as corporate borrowers have sought to offset increases in LIBOR rates with tighter spreads.

Of course, none of this madness would be possible without all that "money on the sidelines" just waiting for the next new issue from Goldman that will grant them a 5% allocation at a spread 75 bps lower than the initial pricing talk.

The wave is being propelled by outsize investor demand for bank loans, floating-rate debt investments that are prized because they tend to perform well in rising-rate environments. The red-hot loan market has enabled many corporations to demand that lenders cut rates or face losing the business to a rival, a sign of how easy financing is enabling large firms to get advantageous terms in debt markets.

Persuading lenders to cut the rate on Service King’s $609 million loan by 0.75 percentage point took just a few days. The new loan will save the company about $4.5 million in annual interest expense that can be used for acquisitions instead, said Chief Financial Officer Michelle Frymire.

“There’s a lot of pent-up investor demand,” Ms. Frymire said. The Richardson, Texas, company has 309 auto repair shops in 23 states and is owned by private-equity firm Blackstone Group LP.

But, at the end of the day, if you"re a pension or mutual fund manager you just have to keep buying because, you know, "animal spirits"...just ask Craig Russ of Eaton Vance.

Investors have poured $17 billion into loan mutual funds since Sept. 1, with $7.6 billion coming in December alone, according to data from Lipper Inc. It is the biggest such inflow since 2013, during the “Taper Tantrum” when the Fed’s plan to reduce stimulus fueled a surge into loan funds.

With few new loans to buy, fund managers who received new money from investors are scrambling to buy existing loans, pushing prices higher and spreads down. Companies and their investment bankers saw the opportunity to refinance and pounced.

“Animal spirits seem to have taken over investor appetite and the markets,” said Craig Russ, co-manager of Eaton Vance Corp.’s $7.5 billion leveraged-loan mutual fund.

While large banks still underwrite large corporate loans, they often sell the bulk of the debt to a mix of mutual funds, pensions, insurers, hedge funds and other institutional investors.

In conclusion:

Meet The New, "Safe" Synthetic CDO's That Could Spell Disaster For The European Banking System

So what do you do if you"re a European banking regulator faced with the task of maintaining a safe, sustainable financial system amid a concerning growth in bank leverage.  Well, if you said sell down risk assets then you"re just being silly or completely ignoring your implicit obligation to engineer higher banking profitability at all costs.

If we can get serious for a moment, like in the early 2000"s, when all else fails you turn to synthetic CDO"s which, courtesy of some magical, if completely incomprehensible, math, slashes the risk of bank balance sheets while having a negligible impact on profitability.  It"s called the Synthetic Collateralized Loan Obligation and it"s all the rage in Europe.

Here"s how it works:

In a synthetic securitisation a bank buys credit protection on a portfolio of loans from an investor. This means that when a loan in the portfolio defaults, the investor reimburses the bank for the losses incurred on loans in that portfolio up to a maximum, which is the amount invested. This amount therefore provides credit protection for a slice of the portfolio, which is often called the ‘first loss tranche’. The size of this tranche is typically chosen in a way to cover at least the expected losses on the portfolio as well as a share of unexpected losses. The bank usually retains the rest of the risk, which is called the ‘senior tranche’.

Before closing, the bank and the investor agree on the terms of the transaction, such as the amount the investor is at risk for, the duration of the contract and the loans that are eligible for inclusion in the portfolio. Choosing which loans are eligible can be on a disclosed basis, where the investor knows the exact names of the borrowers of these loans, or on a blind pool basis, where the investor does not know the identities of the borrowers. In the latter case the loans are chosen based on criteria, such as the type of loans, sector, geography, credit risk, et cetera.

The term ‘synthetic’ comes from the fact that, unlike in a true sale transaction, the loans being securitised are not sold by the bank but are referenced, which means they remain on the bank’s balance sheet. This way, the bank reduces the credit risk on the securitised loans and remains in charge of managing the loans and the lending relationship with their client itself. Synthetic securitisations are often used for hedging the credit risk on loans that cannot easily be sold.

As Bloomberg points out, from the regulator"s perspective the logic is that these deals are usually fully funded, with investors posting the full amount that they"re on the hook to cover should a lot of a bank"s loans go bust. They"re not highly leveraged wagers similar to the pre-crisis synthetic collateralized debt obligations, which were backed by who knows what and sold to whomever.

Of course, the problem with that perspective is that it views the risk profile of the synthetic CLO in a bubble and completely ignores all other possible second derivative implications. 

One such second derivative implication can by linked back to the primary demand for these structures, hedge funds. 

Per the graphic above, hedge funds are all too willing to post the collateral required to backstop losses on a bank"s loan portfolio but only if they can juice their returns somehow.  So how do they do that?  Well, they borrow money from banks, of course.  Yes, you read that correctly, banks are lending money to hedge funds which use that leverage to backstop losses on the bank"s loan portfolio...effectively the bank is issuing loans to backstop loans.

We vaguely remember similar shenanigans occurring roughly 10 years ago when most of wall street"s modern day titans were still watching Power Rangers in their PJs...as we recall, in the end, it didn"t work out well.