I’ll have the CLO equity please

Buy-to-let to ride out renters’ right act, the case for CLO equity

Transcript

SPEAKER_02 0:06

Hello and welcome to another fine minute. I'm George Smith, Global Capital Securitisation Editor, and I'm joined by our ABS reporter Tom Hall and our CNO reporter Thomas Hopkins. Hello. Hello. How are you doing, George? I'm very well. I am coming to you from Hull today, where I'm visiting my brother as we record this on Friday. And I've taken the rest of the day off, so we'll make swift progress through this so that I can go and uh and see the famous deep of Hull, the the aquarium, which is supposedly very interesting and and cool. And to that end, we will start with the buy to let RBS market and the Renters Rights Act in the UK, which came into force at the start of the month. Does this have a significant impact on the R and BS market at all?

SPEAKER_00 0:55

Yeah, it's interesting. So I mean uh maybe I should start by just explaining a little bit about the uh the Renters' Rights Act. So it it makes quite a few changes to the the rental system in England. So I mean one of the big changes is it abolishes section 21, no fault fictions, where landlords could fit tenants without providing a reason. Now they have to be you know in breach of the contract in some way. It also limits landlords to to raising rent only once a year, and it ends bidding walls, which requires landlords to uh you have to lease a property at the advertised uh rent or price. Um and those are just a few of the uh kind of changes. Uh this is quite a sort of meaty piece of legislation. So, you know, there's there's a lot of changes going on in the market, and you would naturally expect that to have some impact in uh when it comes to buy to let R and BS in terms of how it changes sort of underlying originations. So in the story, I I kind of say, you know, this piece of legislation is clearly more favourable uh to tenants than landlords. So there's kind of two main sort of possible outcomes is that you know, less experienced landlords who I've sort of been referring to the article as amateur landlords, uh, will sell you know the property or you know, small number of properties that they own. Uh, and they'll either be bought by owner occupiers, which would probably be the most damaging to the buy-to-led sector, because you'd you'd have fewer originations and it'd be more difficult uh to get sort of a benchmark size if you want to go to the public market to fund your your buy-to-let mortgage book. Or you could see uh those sort of amateur landlords selling uh their properties but they're being bought back up by uh more professional landlords who are better equipped to deal with the new legislation, and then you should see uh sort of mortgage originations uh kind of remaining stable, and they'll they'll be less of a hit to the market in that case.

SPEAKER_02 2:50

Yeah, interesting. I think I should probably say uh uh for fear of upsetting the Scottish family, um, that it it only applies in England, um and Scotland uh already has similar rules. I don't know about what the case is for Wales and and Northern Ireland?

SPEAKER_00 3:07

It's devolved in uh Wales as well, and I think in Northern Ireland, so I think they they set their own sort of legislation.

SPEAKER_02 3:15

So in terms of that kind of shift, then I guess that the shift from amateur to professional landlords is something that has been going on for a while. Is there much exposure to amateur landlords in the buy-to-let R and BS market as it is?

SPEAKER_00 3:29

No, it doesn't seem that way. It seems like in most sort of buy-to-let R and BS deals, they're already composed of majority professional landlord mortgage originations. And that that's kind of I mean, as you say, that the this trend has been going on for quite a while. Uh the shift towards more professional landlords. I I spoke to one mortgage lender who was saying, you know, uh quite a significant uh proportion of their book just sort of two years ago was made up of amateurs and now it's completely uh sort of inverted so that now professionals are making up the biggest proportion of their mortgages. So I I think it it doesn't look like so all already that factor means that it probably won't have a huge impact on existing uh by-tell R and BS deals uh because professional landlords should be less hit by the Renters' Rights Act because they they just have larger teams and are more equipped to deal with the changes. Um and also I think the the other factor is this sort of legislation has been in the pipeline for a long time. It it was sort of started under the Conservatives, and they obviously got distracted with other things. But landlords have been expecting this for a long time. So I don't know if you'd necessarily see you know a big rush of amateurs selling up, and then obviously that that would lead to prepayments rising by more than expected in existing R and BS deals if that were the case. Uh but it it doesn't look like that will be the case.

SPEAKER_01 4:59

Because as I understand it, Tom, it's it's still perfectly possible for landlords to kind of sell a property under the new legislation. I think you have to give slightly longer notice to sort of tenants. But one of the reasons, like uh, you know, aside from you know, like a formal um eviction or anything, one of the reasons you could sort of give notice to a tenant is still that you're going to sell the property, but you know, it shouldn't really pose much of a barrier if landlords do want to sell under the new legislation. It just might be a longer wait, is that right?

SPEAKER_00 5:27

Yeah, yeah, that's exactly right. And there'll be a lot of you know, landlords, especially in the amateur space, who who have kind of said, you know what, we we've had a pretty good run uh for the last you know, sort of 10 plus years, maybe, maybe it's time to you know hand over the keys uh because things are just getting a little bit too difficult now.

SPEAKER_02 5:45

Yes, indeed. And well, that is the the sort of running trend of the market. I mean, I guess one of the things that's sort of been reflected in the specialist mortgage lending market is the kind of resilience and the innovation of the lenders, right? Because you know, Bichelet was huge eight years ago, I suppose, now um, but owner-occupied sort of specialist non-conforming has become bigger since then. Second lean has obviously become a lot bigger. We're talking a lot about bridging these days. Like I guess you know this this isn't something that's gonna sort of knock out the specialist um mortgage lending industry anytime soon, is it?

SPEAKER_00 6:21

No, I don't think so. And yeah, as you say, there they're obviously there's a lot of diversity in the market, and a lot of these lenders uh will offer multiple products. Uh I mean I I think for this story I I spoke to about five uh lenders, so I've got you know quite a few, you know, quite a breadth of opinions about it, and I think all of them have been you know quite sanguine, really, to be honest. Uh that it doesn't look like this is going to you know result in a in a major sort of hit for the market. I mean the the way you know a few of them described it is is just sort of tightening this screw that that's kind of you know been been happening for the last couple years where you know th things have been getting sort of more difficult for landlords where you know whether that be sort of stamp duty or tax changes over recent years, uh which which is kind of you know just reducing the incentive to really uh want to stay in the market when when you can just sort of sell your property and you know throw in the towel. But yeah, I I think on the whole it it doesn't look like this is you know this this clearly isn't the end of the buy to let R and BS market. It seems like it's just gonna accelerate the shift to more professionalisation uh in the market.

SPEAKER_02 7:32

Yes. Well the story is called UK buy to let R and BS to persist despite Renters Rose Act. And it's not the only um piece of regulatory news that we've been covering this week. The Parliament, the European Parliament, the Econ Committee of the Parliament took a vote on Tuesday to finalise its negotiating position ahead of the trilogue with the Commission and the Council over the securitisation regulation reform that the Commission proposed last summer and the reform to the Capital Requirements Regulation. Tom, you you covered this in a story um on Wednesday, and I understand you've also been having a something of a a heated debate on the other Global Capital podcast um with the covered bonds section.

SPEAKER_00 8:24

It was a very, very orderly and polite debate, but uh as as always with uh with cover bonds and securitization, you know, there some some sparks will always fly when when you're dealing with uh two two titans of the sort of debt markets. Um but uh yeah, you you can uh go and listen to the the main global capital podcast if you want to hear a little bit more about that.

SPEAKER_02 8:50

You say main, yes. Um I say other. And uh and finally, um, before we move on to CLOs, there was a a landmark deal that we perhaps should mention from probably the market's most prolific issuer.

SPEAKER_00 9:04

Yeah, so this is this uh Santander auto deal, and it's the uh the first Swedish uh ABS deal. So it's it's definitely a uh a big development for the the Nordic market. Uh you know, Santander obviously already runs a uh an auto program in Finland with uh annual issuance, uh as does also uh local uh Topala. So that that's you know one area of uh the Nordic market, which is quite active. But but now obviously we're we're seeing Sweden uh as well, which is quite interesting because obviously you know Sweden's in the EU, but it's it's outside of the Eurozone, so it's it's similar to uh you you know you you had the multi-lease deal from last month where uh Santander is also using uh a currency swap. Uh so it's issuing uh the senior notes in euros. So that that's another sort of interesting uh development with this deal. And uh yeah, I mean it looks like the deal went went really well. And um, you know, as with any uh new jurisdiction, there's investors who you know it sounded like they wanted to uh buy it but didn't you know have the time to get the approvals. But um, you know, sources close to the deal uh have sort of been saying that they expect when the the next uh Swedish issuer comes to the market, they'll they'll be able to get a uh even better result. So yeah, very very big success for Santander.

SPEAKER_02 10:28

I think there was a Volkswagen deal that was private that I might have covered in one of my first few weeks at uh Global Capital. Um that was that was a Swedish auto deal, but it doesn't seem like uh they've done they've done many more of them than themselves. But maybe there are other issuers who'll be looking at this. Um well if you want to read Tom's story on that, it's called Centre Energises Nordic Market with Swedish Auto ABS Success. And with that, we shall sweep on to the CLO market, where you know it feels like every week we complain about how difficult it is to make any money out of CLO equity, and yet uh people continue to invest in it, Thomas.

SPEAKER_01 11:12

Well, yes, and George, I mean you you said a couple of weeks ago on this podcast maybe to you know maybe now is is is a good time to invest in CLO equity because loads have traded down. And you know, uh I I expressed I think some skepticism towards your your your view on that uh a couple of weeks ago, but you know, I have actually written an article this week talking about why investors are continuing to back CLO equity and some of the some of the advantages of doing so. So let no one say that I you know I'm not capable of sort of uh you know expressing multiple points of view um over time. Uh um I could balance it. It's not been the busiest week of for the CLO market generally, just you know, a couple of deals. We've had sort of a reset from Partners Group of its Penta 10 CLO, and then a refinancing from um from CVC. But other than that, well, I think the CLO market's continued to move at its sort of rather steady pace of sort of two to three deals a week or so since since the war, basically. Um so over the last two or so months.

SPEAKER_02 12:16

So what's the case then for CLO equity at the moment?

SPEAKER_01 12:20

Well, I can certainly say that just on the face of it, equity investors are continuing to sort of put money into CLO equity because we've seen you know deals continue to price, and it that's almost sort of uh deals cannot move forward without CLO equity. So, you know, we've sort of seen um you know, for example, Van Eck launch a CLO equity fund this week. It also does junior junior mezzanine tranches. So there's definitely interest in CLO equity, and this seems odd given sort of the fact that if you look at where the arbitrage is at the moment, it's at one of its lowest levels in over three years, and it's you know at 145 basis points, that's well below a kind of seven-year average of to 207 basis points, then you know, additional sort of additionally to that, you've got sort of the increased default risk kind of resulting from the Iran war. So you would think, why is why is there being sort of continued deal flow? Why um you know are there sort of CLO equity funds springing up? You know, why have uh does money seem to continue to flow into captive equity funds? Well, part of the answer to that is that you know CLO equity needs to be viewed on a on a kind of long-term basis. You know, you have sort of eight or nine years in the life of your average CLO, assuming it gets reset. And so looking at the immediate arbitrage now and the immediate kind of conditions resulting from the the the war and the default risks now might not be the whole story. It's important, I suppose, to remember that these are reinvesting instruments, the returns of which can be improved gradually over time. So I think that's that's at least part of it. The other bit might have to do with sort of what what we've seen with the loan market recently.

SPEAKER_02 14:07

So is it does it come down to my my argument from a few weeks ago that if you've got sort of loans in the nineties, then there is the opportunity to pick them up and uh and when they get paid back at par, you're in the money.

SPEAKER_01 14:20

Exactly, exactly. So it's either you can sort of get paid back at par or you can sort of sell the credits at a later stage as they kind of trade up, and that you know, that tends to flush cash down to equity. So, yes, it it a lot of it does come down to that if you are in a weak arbitrage environment. I mean, of course, you know, there's the possibility of of the ARB kind of improving over time, so it's not just about power building opportunities. The thing about the power building opportunities is that to some extent, and this is where I will return to at least a tiny bit of skepticism here, George. The thing about these power build opportunities is we're we're celebrating quite a small change in where the loan market is. I mean, you must remember that you know, two-thirds of the market was at or above power at the start of the year. We then briefly saw that change to about 4% in March because of a war-related sell-off. Loan prices have now rallied again, and it's about 40% of the market. So managers are having to be quite selective about where they do par build. It's not, and and sources have been sort of careful to stress to me that it's not about going on some wild sort of buying spree of loans in the sort of high 80s or low 90s and hoping that they'll appreciate in value. A lot of this is just very carefully buying loans at say 99 where once they might have been at par or 101, and you know, it's those incremental gains. Um, so that's part of it. But I think you know, there's another side to sort of where CLO equity kind of seems to retain some value for investors, and that's in its relative value. So if you if you look at CLO equity versus say private equity, your private equity tends to have you know just inherently kind of back-ended returns, whereas CLO equity, even if the arbitrage is constrained, you do have kind of consistent cash flow coming through that CLO. So if you're a CLO equity investor, once you've invested, you know, um you will just sort of see cash coming through, you know, at the at the next set of payment date, and the the the consistency of those cash on cash distributions is is quite attractive.

SPEAKER_02 16:27

Yeah, I mean, maybe to return to the power building question. I mean, you know, I guess as we've discussed in the past, there is a reason, I suppose, why lots of loans are now trading lower than they were, in particular. The questions over the situation in Iran and you know this software issue, which definitely hasn't gone away. Like, is it a sort of double-edged sort of bit? Like, I I don't see how people can be confident that this isn't going to go the other way, and and you know, that what they thought was building power is in fact losing it.

SPEAKER_01 17:00

Well, it's it's it's a it's a tricky situation, and as you say, the software crisis is sort of ongoing in in leveraged loans. You know, I mean, some leveraged loans are sort of returned to you know, sort of decent valuations, decent prices since you know the software sell-off, but there is still a lot of concern about risk in that sector. But even just having a look at the war, I mean, it's sort of healthy returns from CLO equity are kind of far from guaranteed. Because, you know, if the Iran war is kind of resolved as parts of the market seem to expect, then you know, loan spreads are unlikely to widen and loan prices will likely rise, and this sort of lowers the arbitrage and restricts managers' ability to build kind of you know the par value of loans in their portfolios. But on the other hand, if the war escalates, as you point out, George, you have this situation where you might have been sort of buying lower price loans and they just simply continue to trade down because you thought they were going to appreciate and they haven't. So there's a little bit of sort of jeopardy here. I think basically what the market is expecting and hoping, and the view that investors that are putting capital into CLECT right now is sort of taking is that they can sort of take advantage of this moment of volatility, and then ultimately things are going to sort of return to normal, you know, to a greater set sort of sense of normality, they'll be able to sort of get some some gains from from you know building par in their portfolios, and um you know, eventually sort of CLO liability spreads will come in as well, which at some point will you know allow for resets that improve the arbitrage, and then maybe uh in additional to that, if if things sort of improve, we get a little bit of sort of LBO activity, which you know would sort of potentially push loan spreads wider. So that's the kind of ideal scenario. But I think what I've pointed out in my article and and and here is that it's far from guaranteed, and certainly market sources have told me, you know, even a source with knowledge of the uh of the Van Eck fund has sort of said that you know the fund managers are being sort of very selective about CLO equity investments at the moment. That you know, there is there are definitely reasons why CLO equity is still attractive to CLOs, but there is a need to be selective because returns are somewhat uncertain given all the volatility in the market at the moment.

SPEAKER_02 19:27

Yeah, I guess it's quite an interesting and and different math to sort of select a deal right now that you like and buy the equity, as opposed to sort of make a commitment to a CLO equity fund, which presumably kind of locks you into the asset class somewhat, come what may, for the next couple of years or or more.

SPEAKER_01 19:44

Yes, this is exactly what a CLO equity investor was telling me. The equity investor was saying, basically, that you know he has a preference for investing directly in CLOs rather than uh in in captive equity funds because ultimately your your capital is captive, it is locked up. That that term is used for a reason that a captive equity fund. And if you don't like how that particular manager's you know, CLOs are performing, there's not very much you can do. It's it's not it's not a liquid fund. Whereas at least if you've invested directly in CLO equity, there is a secondary market. Granted, you you don't have daily liquidity, and if you've got you know some really distressed-looking uh loans in the portfolio of the of the CLO you've invested in, uh, you might struggle to offload that equity, but there is a secondary market you can pull out. Um, and this is particularly if you've taken the minority position in in CLO equity. If you've bought the majority, there are a sort of select number of you know specialist kind of CLO equity investors who will kind of buy up the majority in the secondary market, but a lot of the secondary market trading is is minority stakes. Um, but there are you know there is room for some investors to be quite sort of nimble about buying up a minority stake in uh in an attractive looking CLO, realizing some gains for you know a little while, but if ultimately the situation's not looking, you know, if the returns are not quite what they were hoping for, they can sell out. So yeah, you're right, George. There is a sort of it's a different evaluation that investors have to sort of take into account when they're investing in a captive equity fund or directly into CLO equity.

SPEAKER_02 21:23

Well, I think we shall leave it there, the story on the website, and it's called Investors Take Long Term View on CLO Equity Returns, which leaves me to say thank you very much for listening and goodbye.

SPEAKER_00 21:36

Goodbye. Goodbye.