Why invest in CSOs vs CLOs?

October 17, 2019
In the first part of this blog series, Kurt Koschnitzke, Executive Director, structured credit Trading, Nomura and Gaurav Tejwani, Portfolio manager, Brigade Capital Management outlined the different aspects of tranche trading and its future prospects. In this second blog the panellists compare CSO vs CLOs, short trading for CSOs, trading of whole capital structures and future prospects for the market. This blog is taken from the Quantifi webinar ‘Trends in Structured Credit Markets’, moderated by Dmitry Pugachevsky, Director of Research, Quantifi.
 
‘The views and opinions expressed in this blog are those of the individual and not of the companies they represent. As this blog has been transcribed from the webinar recording, there may be minor differences’
 

There is a growing trend of of CLO, ABS or other cash traders entering the tranche market and trying to pitch their created positions with tranches. So how do we compare CSO versus CLO? 

Kurt: This is a question that comes up a lot and whilst I admit I am a CSO trader, I also think these two products are supposed to live together in most structured credit books. Having said that, there are a lot of advantages to CSOs that I like pointing out – the biggest of which are the elimination of warehousing risk. As an equity investor, you can assemble your portfolio and ramp up in a matter of hours and put your view to work without changing market conditions over many months. 
 
Secondly, when you are comparing returns between a synthetic tranche and a CLO bond, I always like to bring up leverage terms. Rightly or wrongly, I have found that banks will extend far more credit against synthetic tranches. For example with equity IAS I have seen as low as 10% compared to haircuts on CLO double B's that are sometimes 40%.
 
The final point I like talking to CLO investors about is the equity call option in CLO structures, which I think is often mispriced in those deals. So if you are looking to invest in the senior part of the capital structure and you like where your risk is pricing, maybe the CSO market is better for you. For example, you are not going to get called out of that spread by the equity guy looking to refinance the deal when spreads tighten. Whilst I cannot tell you how to price that option in the CLO market, I just think a lot of times it's under-priced.
 
Gaurav: As similar as the two products may be, the differences between the two is one being seen as a cash flow product and the other being seen as a derivative. I think the participants will continue to be somewhat different although there will be some overlap and I think despite the risks being somewhat similar they will behave differently and you have to respect the market and the way things are priced. 
 
They both have their own advantages and disadvantages, synthetic tranches are significantly simpler in their structure and the fact that they are typically static also makes them fairly easy to value. The complexity of CLOs makes them really hard to value mathematically and that complexity is what makes the market, ironically enough; simple. Because it is hard to model them with precision, at best you can run certain scenarios and run certain stats on the underlying portfolio and trade it based on certain thumb rules or look at where similar products traded in the past. As long as this is the case, they will behave very differently. I think one key risk from the perspective of an investor is the mark-to-market behaviour - CLOs do not move on a day-to-day basis because cash flows do not change on a day-to-day basis and therefore give you the impression of more stability. 
 
On the other hand, because CSOs are priced based on a model, they jump around every day. Some people will argue that they capture more noise than true signal and that is a matter of personal opinion but the fact is on a daily basis they are trying to capture the information as indicated by the single name credit default swap market. Therefore, from an investor's point of view, CLOs will always appear to have a higher Sharpe ratio than CSOs, of course for large moves it won't matter because eventually fundamentals catch up with any product, irrespective of what kind of method you use to mark them. I think the fact that there is more price stability in CLOs is an important aspect of the market, and also the fact that CLOs are rated, changes the whole dynamic. From an investor's point of view there is nothing right or wrong, this is just how the market is. At certain points in the market you will find one to be cheaper or more attractive than the other and at certain points of time you will find one to be a better short, especially on the CSO side I guess it's hard to short CLOS. That is the structure of the market and from an investor’s perspective that is what makes our jobs interesting or exciting because it is a portfolio manager or trader’s job to compare two similar products that trade very differently and price very differently.
 
Figure 1: Investing in CSO vs CLO

 

Can you tell us more about the aspects of short trading for CSOs?

Gaurav: I think the question on being able to short risk is as valid for index tranches as much valid as it is for bespokes. You have to keep in mind that the majority of trading is from the long risk side and the short risk side is not common, although if you discuss the possibility of going short risk in bespokes it does not surprise anyone. That being said, even within the shorts I think a good fraction of those shorts are in a long short format. For example, an investor may want to go long equity risk and short the mezz or vice-versa or they may want to do some kind of a curve trade where they could go long and short - somewhat similar portfolios in different maturities. It is an interesting way for people to create a profile of defaults. If you think of tranches in the form of an option instead of just being long the equity tranche, which is a longer call option, you can create structures like call spreads or 1x2 calls or calendars etc. 

 
I have seen some instances where people have used bespokes as a true outright short, not just to hedge along in another tranche or an index tranche, but truly to hedge their portfolio. Anecdotally we've seen some instances of that and often you may not know what that investor is trying to do - are they truly just bearish on the market and think that names will default or do they have other longs in their portfolio that they think can be can be hedged,  especially against defaults using certain bespoke tranches. I think the fact that you can go both long and short is not just a good tool to have in the toolkit, I think the other purpose that it serves, and which is very important aspect, is it keeps the overall pricing in the market very honest. It ensures that products cannot just trade extremely rich or cheap to fair value because irrespective what the cost of capital or the transaction cost may be there is a price at which certain market participants might come in and take the other side of the trade and to me that makes it quite exciting.
 
Kurt: I agree with what Gaurav said, I have seen both types of short credit flows in bespokes. The one thing I would like to point out is that it is a great tool for constructing a short view on a sector for example and I always caution on liquidity. I think it is yet to be proven that you will be able to monetize a short and a bespoke tranche and that is my one caution. I think CSOs offer the opportunity to build short trading structures from going long to tranche because all of the other underlying’s of a bespoke tranche are liquid, you can certainly put together strategies on your Delta hedges that trade net short. I've seen that a lot and I think that can be a very successful trading strategy.
 

When dealers are trading bespokes, they try to trade the whole capital structure to find investors for all the tranches in the capital structure or so we are told. Kurt, can you maybe start a discussion on how dealers are willing to trade non -full capital structure?

Kurt: I actually think dealer’s ability across the street varies on this topic. I will say Nomura is on, what I view to be, the quite conservative end. My capital charge is very punitive if I leave open part of the capital structure, so just as a matter of trading with Nomura, I have to have the equity tranche placed, certainly everywhere through expected losses. I can leave a gap in the mezz or senior for a few weeks if I place that because the pipeline there is quite strong and we are confident we can place that. I have heard empirically from my trading partners that there are other counterparts in the street that are have far more flexibility in terms of that. I will say, I believe that the ability of some of my counterparts at other banks to trade open capital structures, led to a little bit of a glut in terms of mezz or junior mezz through the summer that is still waiting to go through.
 
Gaurav: I think someone who is on sell-side is better equipped to handle a question on what is punitive from a regulatory standpoint and what is not. We get to see snippets of it on the buy-side as we are shown deals from different dealers on the street. 
 
It does not look like we will see too many of the single tranche bespokes that used to be issued pre-2008. Regulation is punitive enough that banks, of course, try to place the full cap structure, but in case they don't, it's not because they want to warehouse certain risk forever or take that as a proposition. It is probably because they felt that trying to place all the tranches on the same day, versus occasionally holding on to one or two slices and waiting for a week or two or a month to place it on a later date at hopefully a better level. That is a risk they are taking in this syndication process and sometimes they will do that, but that's very different, as in not placing one part of the cap structure is very different from the old days where the entire deal involved just placing one tranche. I think that is a decision the structurers at the bank have to take to whether the ability to place it in the future, at a much better level, is worth the risk and the capital charges involved.
 
Kurt: I agree. The days of single rated junior mezz issuance in single tranche deals are done as far as I can tell, the capitals is way too expensive for that for me. Gaurav summed it up exactly right, we will hold a senior part of the capital structure if we believe we can get better execution in the future or if we're happy at the price where we left that piece as a short to medium term view.
 
One of the interesting recent developments was that high-yield tranches are now quoted up front with the same running 500 coupon. Is this a positive development that brings more liquidity to the market?
 
I think that's a positive move for the market, Nomura does not trade in index tranches so I'm not in the tranches and can't comment on that but the analogy to the bespoke market I think is good. I've talked to counterparties about doing a similar structure in bespoke because obviously if I can strike all my tranches at K=100 for example and get my hedges off at K=100, I'm not left with this annuity risk that's built up in dealers’ bespoke books over time. In theory, I've argued to counterparties that that will get them more liquidity and better execution versus mid if they're willing to like that in the bespoke tranches. So I have to imagine this helps everything in the liquid world, all the replication trades, you've eliminated coupon risk etc. I think it's only a good thing. 
 
I think standardizing coupons on average is better for the market and I think the same applies at the index and single name level. If all the single names in the index have the same exact coupon, then index arbitrage is much cleaner you are not left with timing of default risk on a particular name. The same is true for tranches - if all the tranches within an index have the same exact coupon then you can create near perfect arbitrage in the tranches. If you go long all the tranches and short the index or vice-versa you are not left with second order risks such as the exact timing of default and that could that could make it harder to run that arbitrage and therefore it is good for the market and keeps the markets more efficient and more liquid. Of course, it does create problems for those tranches that trade far from the stated coupon. Equity tranche investors are used to seeing low dollar prices like 50 cents on the dollar but it becomes rather nuanced for super senior. For example, high-yield super senior on their own tends to trade at let's say 30 basis points and with a 500 coupon we are talking about dollar prices of 19 points up front the other way if you want to think of it like a bond it's like a bond trading at $120 price. Now that creates second-order interest rate or other risks to the tranche holder. Some people may not want to take those risks, but I think these second-order risks that are created are minor inconveniences relative to what it provides to the market which is a lot more efficiency through the cleaner arbitrage situation between single names and index, and index and tranches. Overall, I'm a proponent of fixing coupons.
 

Do you think we will see rating for tranches anytime soon at all? 

Kurt: Yes, I have already hinted that I think that is in the works at many banks. From my point of view, I see that happening in the middle of next year by the time that all gets sorted, prior to that I think the more imminent innovation is managed deals coming to bespokes, I think that's in the short-term.
 
Gaurav: This is one part of the market that I personally find a little annoying. The obvious first step would be to have indexed tranches rated, as they are the most liquid product within the tranche market. Then you could get new types of strategies or new types of players involved in the market but then the question is who pays for it? When you have a bespoke tranche it's fairly straightforward: here are the three or four investors that were involved in this deal and here's the bank that's structuring it, so you can you can tag a cost whatever it is and go and pay Moody's or S&P or Fitch to provide a rating on that transfer. When it comes to index tranches, it is a fair question to ask who should pay for it, there are so many participants, there are so many dealers, and then there are other third parties involved. It is annoying in the sense that there is no clear answer and therefore ironic as it may be the product that is the most liquid and the most transparent out there might be the last one to get rated.

 

Part 1: In this first section, the panellists discuss which tranches are more popular now: index or bespoke and which tenor is more popular in bespokes?

Part 3: In the final blog in the series the panellists answer questions from the audience on CLOs, bespoke portfolios and more