Private Credit CLOs - Short

"So, a prospective fund, wanting to bet against these loans, could be the first to purchase credit default swap contracts on the subordinated tranches."

A prolonged period of economic bliss has lulled markets to sleep, hence the prevalence of “payment-in-kind” loans. When the tide turns, however, those who could never pay cash interest, dependent on a rosy future to refinance – will get tattooed. And now, very naturally, banks are slicing, packaging, and selling these loans to investors, ravenous for yield.

I’m a young analyst, but to my knowledge, there isn’t a derivatives market for private credit collateralized loan obligations yet. So, a prospective fund, wanting to bet against these loans, could be the first to purchase credit default swap contracts on the subordinated tranches. Too, these tranches have an “investment grade” credit rating; spreads should range from 0.5% to 2% – a highly asymmetric risk-reward, as opposed to a traditional short.

ANTR 2018-3A (Antares Capital), for instance, has a current balance of $734 million, totaling 156 loans – 77.21% are Caa3 rated. Class D (BBB-) credit support and tranche thickness sit at 18.11% and 5.49%, these are important figures – lower is better. This security, however, is a black box; I haven’t accessed any data thus far. But if nearly all of the loans do turn out to be junk, buying insurance on this tranche could prove lucrative.

The case laid out above is preliminary, mainly because I haven’t conducted a thorough analysis of the underlying loans, my understanding of derivatives is elementary, and negotiating a master agreement with the ISDA brings added complexity. That said, it’s evident that lenders have prioritized volume at the expense of credit standards, and their laxness can be profited from.

“I think if you just pay attention, you’ll get a warning sign. Heck, you know when I figured out the subprime thing, I had to do it off human behavior, and various sources of witchcraft wizardry (laughs) in 05’ – by early 06’ it was apparent in the actual filings that were being made every month, and you just had to look at that, and it was really easy.” - Michael Burry

The Cliffwater Corporate Lending Fund (CCLFX), a roughly $32 billion private credit fund led by Stephen Nesbitt, provides a decent proxy on what’s lurking in these tranches. Nesbitt has regarded the CCLFX, with +3,800 credits, as an index for the asset class.

From their filings, I calculated the fund's percentage of PIK loans, and overall loan growth, since inception:

PIK loans as a % of the fund:

2019: 0% – 2020: 0% – 2021: 0.24% – 2022: 1.19% – 2023: 4.58% – 2024: 5.77%

Loan growth:

2020: 390.6% – 2021: 552.1% – 2022: 37.6% – 2023: 46.4% – 2024: 48.4%

Here’s Burry, regarding the pay-option ARM, which is similar to today’s PIK loan – “In this new type of mortgage, never before seen, in a widely standardized format, the borrower could basically pay next to nothing each month, and the unpaid interest would simply negatively amortize into the growing mortgage balance. Rampant cash-out refinancing had already made the home a magical ATM for most Americans, and now housing had its credit card. This is what I had been waiting for – peak credit. Such a mortgage product would only exist as long as home price appreciation was the central assumption, and home price appreciation was not long for this world precisely because these mortgage products existed.”

Further, in the fall of 2013, Howard Marks wrote a memo to clients titled “The Race Is On”, describing the current environment as akin to the years leading up to the GFC – here’s an excerpt: “There was widespread structural deterioration. Examples included covenant-lite loans carrying few or none of the protective terms prudent lenders look for, and PIK-toggle debt on which the obligors could elect to pay interest “in kind” with additional securities rather than cash.”

Almost 12 years later, Oaktree has a private credit fund riddled with PIK loans and an educational video on CLOs uploaded to their website. More surprisingly, Marks’ most recent memo, titled “On Bubble Watch”, didn’t mention PIK once.

We’re unequivocally at “peak credit”.

“How did you go bankrupt? Two ways. Gradually, then suddenly.”

―Ernest Hemingway