Guide to CLOs

10. How the secondary CLO market works

One of the biggest changes that has taken place in the CLO business since the financial crisis has been the emergence of a secondary CLO market.
Held until maturity
Previously, CLOs were mostly bought at issuance and held until maturity, as were most other kinds of structured finance assets. However, as the financial crisis of 2007 and 2008 took hold, many of the original buyers of CLOs decided to sell. This created a secondary market around 2008 and 2009. Some holders feared (without justification as it turned out) that CLOs would experience the same disastrous performance as CDOs backed by subprime mortgages. Many were required to sell because their CLOs were downgraded, making them ineligible investments for some funds or uneconomical under bank or insurance company regulatory capital requirements.
When investors sold, the buyers were most often hedge funds. Some funds were set up in the immediate post-crisis period with the specific aim of taking advantage of the low price of structured finance assets. Other existing hedge funds had a broad enough remit to allow their managers to switch from other assets into buying CLOs.
As a result, the make-up of the CLO investor-base changed dramatically. The new holders saw CLOs as a trade rather than as a one-off investment. They were usually keen to sell their investments and lock in a gain once their purchases had recovered in price. This fuelled further secondary market trading.
Even as long-term investors returned to buying CLOs the secondary market remained active, perhaps suggesting a long-term change in the nature of the business. The ability to buy and sell in the secondary market has become an important part of the appeal of CLOs, and gives investors a better idea of the value of their investments at any time.

Trading is history

CLO-i, a data service run by Creditflux (see page 162 for more details), has been collating data on CLO b-wic colour since 2009. Its users can therefore search to find out quickly if a CLO has previously appeared on a b-wic and what its cover level was.
In the case of a few widely traded bonds, it is possible to turn this into a timeline of prices. While nothing like as complete as the daily price of large corporate bonds, this provides a clear indication of how the price of the bond has changed during its lifetime as credit conditions have changed and as the bond has matured.
How big is the secondary CLO market?
The secondary CLO market was not a completely new phenomenon in 2008 and 2009. An earlier burst of secondary trading had taken place following a previous crisis, when the poor performance of corporate bond-backed CBOs persuaded UK bank Abbey National to sell its large portfolio of these investments. That sale, in 2002, also encouraged other trading, but the secondary market was short lived. Secondary volumes declined to almost nothing in subsequent years.
Since 2008, volumes have grown to more than $46 billion in 2020, as the chart opposite shows.
However, the amount of secondary trading in CLOs is still small compared to the volume of outstanding securities. A few relatively widely held bonds change hands several times in a year. Most trade much less frequently and many CLO liabilities have never traded since they were issued.
How CLOs trade
The CLO secondary market is an entirely over-the-counter market. That is to say, there is no exchange on which CLO trading takes place. (Many CLOs are listed on the Irish Stock Exchange but this is done to meet the requirements of some investors who can hold only listed bonds rather than in the expectation that they will trade on this market place.)
CLO trading almost always takes place in one of two ways: either as a one-off trade between a dealer and an investor or as part of a bid-wanted-in-competition list (a bid list, or b-wic).
Quarterly secondary CLO trading volumes, based on b-wics ($bn)
Pinch to zoom in
One-off trades
Large dealers such as Bank of America, Citi, Deutsche Bank, Goldman Sachs and Morgan Stanley hold inventories of CLO debt and equity, and they regularly send their clients lists of the CLOs they hold with an indication of the price at which they are prepared to sell.
An investor with a chunk of CLO debt or equity to sell might simply call a handful of dealers to see which will give it the best price.

Brokers, dealers and broker-dealers

In theory, there is a big difference between a broker and a dealer.
A dealer is an institution that buys assets and then sells them at a later date or in a slightly different form in order to make a profit. The dealer takes ownership of the bonds and will have some bonds on its balance sheet at any time.
A broker, by contrast, does not own the bonds at any point but simply takes a fee from a seller for finding the buyer. Whereas dealers tend to be large banks, brokers can be smaller firms.
In reality, the demarcation between dealer and broker can be somewhat blurred. Some small investment banks are involved in the market as dealers but take few positions. Large dealers will happily act as brokers if they can match up a buyer and seller without the need to use their own balance sheet.
To add further confusion, in the US especially, many firms are referred to as broker-dealers, indicating that they can act in either capacity.
When an investor has more CLO debt or equity to sell it usually holds an auction known as a b-wic. Despite some initiatives to bring greater sophistication, the process of organising a b-wic is fairly crude. The holder simply circulates to dealers and brokers by email or another messaging system a list of the CLO pieces it wants to sell. It sets a time and date for the end of the auction. Typically, the list of securities might start to circulate three or four days before the deadline.
Ahead of the auction deadline, dealers and brokers forward the list to their clients (without revealing the identity of the seller). Brokers make bids for the securities on behalf of their clients. Dealers may put in bids on their own account or on behalf of their clients. At the deadline, the investor chooses the highest bid for each asset and, if it wants to trade (or “hit the bid”), contacts each of the winning bidders to conclude the trade. Alternatively, some or all of the bids may fall short of the investor’s expectations and no trade will take place.
By convention, the seller then circulates “colour” on trading to all the bidders. This consists of an indication of whether each CLO asset traded or not and a price level. However, this price level is not the successful bid price for each asset, since the seller has no reason to tell the market the exact price at which it completed each sale. Rather, these prices are the second highest bid, known as the cover bid.
This dissemination of cover bids provides valuable information on price levels in a relatively opaque market. Some investors use this information to value their holdings. And market participants occasionally accuse investors of carrying out b-wics as a “pricing exercise”: in other words, simply to gain pricing information, rather than with any real intention to sell.
For dealers, b-wics can be an important source of inventory, and dealers are often some of the most active buyers on bid lists. Dealing desks buy CLO assets with a view to selling them to clients later, especially when they believe that their market value is likely to rise.

Opinion – Unmesh Bhide, Chief Product Officer and Head of Sales, PricingDirect

Q. Let’s start with the basics. How would you define or use a CLO valuation?
A. For any security, a valuation is an estimate of the price at which a willing buyer and willing seller would transact in the market. There are different processes for primary and secondary market CLO valuations, and I will be talking about secondary market valuations. Secondary market valuations are used for a variety of purposes, such as trading, repo, or to calculate a portfolio’s net asset value.
Q. Can you walk us through how investors approach valuation at the moment?
A. There are two main approaches to valuation - mark-to-market and mark-to-model. Most investors use a mark-to-market approach to measure performance because this is where you can expect to execute a trade. The mark-to-model approach is used primarily for fundamental analysis, such as estimating CLO mezzanine and equity tranche returns over a business cycle or for asset allocation.
At PricingDirect, we calculate mark-to-market valuations by generating cash flows, using industry standard expectations of prepayments, defaults, recoveries and reinvestment. These cashflows are then discounted to a present value. The discount rates are based on recent market observations such as comparable trades, dealer bids or offers.
While the mark-to-model approach uses a long term outlook, the mark-to-market approach seeks to estimate the current-day market expectations of price. In times of distress, the price differences between the two can be substantial, but the mark-to-market valuation will be closer to an actual exit price. A great example of this was in March 2020, when the first impacts of the COVID-19 pandemic were felt. Market expectations were for the worst-case scenario, leading to much lower trade levels versus mark-to-model valuations. In addition, bid/offer gaps were also much wider during this period than mark-to-model estimates, given the leverage-related distress among certain CLO investors.
Q. It seems like there are many different approaches. What would you suggest for new CLO investors?
A. Most investors use a mark-to-market valuation, because that is where you can expect to execute.
CLO debt valuations benefit from increased trade activity and market color. Note, however, that CLO prices still range even within a single rating category because of the wide variety of managers and styles. Volatile markets exacerbate these ranges due to illiquidity and forced selling.
CLO equity valuations require a more granular approach since cashflows to the tranche depend on the performance of the weakest collateral. One must analyze loan portfolio performance under various credit and rate scenarios, as well as vulnerability to black swan events, such as the COVID pandemic, to accurately price the equity.
Q. What are the different qualitative and quantitative inputs needed for an accurate valuation?
A. In my view, the most important qualitative input is the CLO manager. This takes into account their platform size, historical performance, investment style, credit background, and capability to source loans and execute efficiently in the market. Quantitative inputs include structure-related aspects such as coupon, call date, and reinvestment period and collateral metrics, including MVOC, NAV and underlying loan data. To increase granularity we run loan-level cashflows, based on individual loan assumptions.
Accurate valuations also requires the vendor to be well informed of current market conditions and color. PricingDirect has direct access to market color and major participants, which affords our evaluators the ability to quickly and accurately react to volatile markets. For example, PricingDirect can adjust the importance of certain inputs and assumptions depending on the current market cycle.
Q. Do investors calculate their own valuations or use an external valuation provider?
A. Regulators increasingly favor that market participants utilize independent valuations and thus we are seeing more institutions utilize third party valuations. Funds may also use a third party pricing vendor for internal model pricing as well as official NAV calculations.
Q. What are your thoughts on how people should pick a pricing vendor?

A. Investors should back test the vendor’s valuations over the credit cycle, focusing in on periods of market volatility, to gauge whether the vendor accurately reflects the market. They should also focus on the vendor’s controls around the valuation process (i.e. SSAE 18 type II compliance). Both of these requirements are related to the SEC 2a-5 valuation rule, which will be going live in September 2022.
Unmesh Bhide Chief Product Officer and Head of Sales Unmesh Bhide is a Managing Director at J.P. Morgan (formerly Bear Stearns), and the co-founder of and the head of product development and sales at PricingDirect. Before joining Bear Stearns in 1997, Unmesh developed valuation models at Merrill Lynch Securities Pricing Service. He also worked in a fixed income portfolio management capacity for Daiwa Securities Trust Company.