Hello, and welcome to The Credit Edge, a weekly markets podcast. My name is James Crumby. I'm a senior editor at Bloomberg. This week, we're very pleased to have back on the show Lisa Lee, who covers all things credit for Bloomberg News in London. How are you, Lisa fine?
Thank you, Thank you for having me. It's actually a very warm day in London, very unusual.
Great well, very excited to get your take on the markets. Thanks very much for joining us. We're also delighted to see Urun Julius, a credit analys with Bloomberg Intelligence in London. We'll be coming back to Urun a bit later to talk about banks and eighty one's and the aftermath of the credit Swiss collapse. So do to stay with us. But first, Lisa Lee with Bloomberg News, you're our global guru on clos, which we've talked about quite a lot on this show. But let's start with it an easy one.
What is a clo, how do they work?
And why do we care so colos buy up lavish loans? What are leverage loans? First of all, you ask, those are debt loans of junk rated companies. So those on the edge of bankruptcy, but nonetheless still can produce very good yield and usually back pees buyouts and companies like as wide ranging as American Airlines to Burger Kings and colos are the biggest buyers, and they buy them to turn them into bonds that they sell on to other investors.
Okay, so issuance of clos hasn't been that active this year, but we have been kind of hearing about a revival potentially this month. Has that started yet? Are you seeing a big boom in COLO issues right now?
I think what we're seeing is a lot of boom on COLO aspirations. So there's a lot of managers who are hoping to dos because as you said, there's issuance has been very weak. You look now we're in September. You've got really three and a half months to get deals done, and so people are hoping maybe we can get one deal done, two deals down before the end of the year and make something of this year. So it's not a total, sort of a really bad week year.
The problem is everyone has the same thought. Everyone wants to do a deal right now, and the problem that's been riddling them all year long has now gone away, which is that they're just not as enough leverage loans to turn into bonds. And what is that has done is push leverage loan prices higher, too high for them to do a deal that pleases every investors in their
capital stack. And as a COLO, you have to please every investor or, you're not going to really have a popular, economic, robust COLO.
Interesting And at the same time, we're seeing a lot more hedge funds getting into clos. Who's jumping in and why are they getting in now?
So hedge funds are getting in because you know, one thing you've noticed is hedge funds it's a great business. It can make so much money. It's two and twenty and so there's a lot of volatility in hedge funds. You make tons of money, but you can also lose a lot of money colos as a manager. As a manager of colos, which is versus an investor who buys the bond, but one who buys the loans, packages them up and then sells them. It's a very steady fee business.
And if you're a hedge fund already that has a lot of credit focus. For instance, Arini is a hedge fund by this very famous former credit Swiss corporate trader. He knows corporate debt and so that's his hedge fund. And so to move into COLO is a very easy ancillary business and it provides a steadiness that perhaps, I mean,
hedge funds don't have. And and I think why now, there's always people are always thinking like there's always a good time for steady business, and you're thinking about this for a long term platform, not just for this moment. And so we're seeing a bunch of them, not just Areni, but surround Carvel. A number of hedge funds are trying to get in. And remember remember there's already a number of hedge funds who have COLO platforms, like King Street and Anchorage.
Sorry, that fund you mentioned is Irene Arenis.
He is an Arene's the word for parrot, and he's a big fan of parrots.
Great, okay. And so these hedge funds that are coming in new to the asset class, are they doing big deals or just kind of testing the waters right now?
I think what they're going to do is to just get their first deal done. Usually, if you want to start a COLO business, regardless of whether you're a hedge fund or an asset manager. You have to hire a very well known, well regarded COLO manager that's experienced for the market to trust you. So they've all done that.
They've all hired a COLO manager, and now they're meeting many of them are meeting with investors, trying to pitch how they are different and trying to see if they will be interested in their deals.
I've got to ask, and I know we've talked about this before, but hedge fronts clos I mean, it all sounds like a risky business to me. Why should we not worry about this?
Well, I don't think we should not worry about this. I mean there are systemic risks involved with these kind of of securitized products, and the Bank of England and the Treasury and the IMF have warned that corporate dead could be an area of systemic risks, so we should worry. At the moment, we're seeing fairly low default rates. But one area of real concern is low. Default rates are fairly low, but we don't know whether they will stay that way. And the defaults are of the leverage loans
that they repackage. And what one thing that I've been reporting on is how low recovery levels are so defaults are like when a company goes perhaps goes bankrupt. Recovery is how much money investors lenders get back when something goes back. So it's so for a investor, it's not just default rate bankruptcy numbers, it's also times that with how much money they get back, and the recovery levers have been astonishingly low, historically low. So usually colos got
seventy eighty cents back after a company went bankrupt. Now they're looking at more like twenty five cents, So that is really changing how they have to think about their investment at the moment. I don't think they're pricing this in, but people are getting more and more concerned. So one thing you've seen in Europe is some brigade capital management retool.
There exists two of their existing colos so they can better fight off what some people have been calling lender on lender of violence or credit or on credit of violence, where maybe a aggressive hedge fund comes in, puts in new money and pushes other investors other lenders down the priority line. And because of this kind of maneuver, some bankruptcies have produced zero for for first lean lenders.
So you raise a lot of issues at least, I mean, I've got to start trying to unpack some of them. But you're talking about hedge funds getting into clos At the same time, some of the risky maneuvers that they're they're doing are what we have called creditor on credited violence some clos in response to trying to rework their their rules to make it tougher to to pull those things off. It all just sounds like a total, total mess.
I mean, and then and then at the same time, because of these aggressive strategies, the recoveries when you go through a default are much lower for for investors. I mean, what's the takeaway here? I mean, it's this market just becoming a total scrap. And I mean, is it is it getting more risky as a result?
Oh, I want to say it's having a total scrap. I think there's a lot of things to worry about and things to watch for. As of as of now, the faults are still low. As of now, recoveries are low,
but they could go higher as of now. But it also sort of depends on the broader economy if how interest rates go where if we have a recession or not if interest rate, if inflation picks up again, or if the FED doesn't manage a soft landing and we go into a recession, then I think that this becomes more and more of a worry because hedge funds, not the ones, even the ones we have have COLO shops, have raised a lot of money for distressed situations, and they have pools of capital ready to put to do
these aggressive tactics, and they could really leave the COLO and levision role market in a lot of damage.
But let's get back to where you started with the hedge funds getting in and they're getting into this business because it is a stable fee generating business. At the same time we're saying that it's it's under a lot of pressure and there is getting more volatile. I mean, how do we square that circle?
Because the manager is not up for the law. So remember I told you the manager sells the bonds. The people who get hurt are the bonds, the people who bought the bonds, not the managers who sold the bonds. So getting into the steady fee business, you've hopefully, hopefully put off the risk to somebody else. Now, the problem oftentimes with any kind of financial crisis that you think you've sold off the risk, you haven't. But in this situation, it really does seem like they've sold off the risk.
But it doesn't mean that that risk goes somewhere. It's never it never disappears. I think that's the kernel of truth and finances. You can move away risk, but you can't make risk disappear. So it's just in other people's pockets that this problem exists, and.
It may take a while for that problem to show up. Yes, okay, so let's just go back to the rule changes that we're talking about in some of these clos to try and fend off these attacks by aggressive hedge funds. Will these amendments become an industry standard?
Do we think in the US they become. They're more standard than in Europe. But I've talked to managers and lawyers and they definitely think that this will pick up, that there is great interest in doing them. Doesn't take that much effort. They've like sort of innovated them to the point that it doesn't cost too much to do and there's only benefit to have it, and there isn't much of a downside to not having them. So I do think it's going to become more of an industry norm.
But we'll see sometimes people can get really complacent.
And so let's just go back to the original point about clos. You know that they are basically repackaging loans to pretty you know, stable, you know, large companies that are household names. Does that make them more or less risky? And what's their performance being over time? I mean, is this something like the CDOs that are really very dangerous or has it been a long term performer?
First, for the longest time, clos were one of the areas in the securitization market that performed fairly well during the financial crisis, which is the reason why they came back post crisis. So CE deals never came back. CBOs never came back in the way they were. So they did come back, they did perform well. But past is not pro blogs to the future, and the markets changed a great deal, so it's not to say that that
can't cause issues in the future. But history has shown them to be pretty sturdy, and they've worked to become more sturdy. But it's hard to know given all the changed market and the way hedge funds behave now and how restructures are going a lot of it will depend on how bad a recession there is and how bad and how high inflation is and how high interest rates are.
So on that point, and before we talk to your own Julius Bloomberg intelligence about the banks, what else is on your radar? I mean, as you say, the economy in Europe particularly doesn't look great. Should we be worried about risk assets here? You've also been writing a lot about private credit. Is you know, bigger and bigger deals, more and more fundraising. Is it all rosy over there as well?
No, I think there's Well, it depends on who you're talking to. The private credit mandre just having a great time raising money. And since we started with clos, they're looking a little worried because private credit is taking away a lot of the loans that they used to repackage. So they're worried there. And a big topic right now is private credit clos So should we more move more to private credit clos? Should we securitize this? Private credit in the US is already happening, and it's picking up
and it's booming. It's actually the one area of the clo market that's booming and Europeans managers were wondering whether they can get into the action as well. So in one so there's they're worries about how much private credit is taking away from the leveraged loanwark gets as high yield and lavish loan and private credit sort of converges, and the same time people are all thinking about, okay, well then what's the opportunity next, Well, how can I still make money?
So we really will be working very close at your coverage to kind of figure out what's going on, why it's happening, and what are the risks. It's a really fascinating one to watch. Great stuff. Lisa Lee from Bloomberg News, thank you so much for joining us.
Thank you for having me. It's been a pleasure.
As always, read all of Lisa's scoops on the Bloomberg terminal and of course at Bloomberg dot com. Moving on to another big topic. As I mentioned earlier, we are very fortunate to have with us Urun Julius, who covers credit for Bloomberg Intelligence based in London, and it's focused on the banks. How's it going over there?
Urun?
All good? Thank you very much, s James, and thank you for having me on the podcast.
Thanks for joining us. And last time we spoke, Credit Suisse, which was deemed at the time to be a global systemically important bank, collapsed. That was in March. How has that impacted the European banking sector? What was the fallout there?
Well, I think it may have done some permanent damage to Switzerland's reputation of calmness and predictability, But the impact on the wider European banking market and more specifically on
the eighty one market, I think is more nuanced. I think most eighty one investors have concluded that there is no readacross between Switzerland and some of the other jurisdictions EU and UK regulates that came out quite strongly in back in March in support of respecting the claims hierarchy in case of a bank failure, and I think most eighty one investors have also concluded that there's no reta
cross between credits Feeze and other European banks. If you look at the banks credit fundamentals, you know these have quite quite resilient and judging from their second quarter results.
Okay, so let me start you there. You mentioned eighty one's which stands for additional tier one. It's a type of risky bank debt. But before we get into the sort of details of what's going on there, can I ask you just to please describe what those are, how they work for those that aren't aware.
Yes, So these are the most junior type of instruments that banks can issue, mostly in Europe, but also in a lot of other jurisdictions outside of the United States. And they see just above common equity, and they share with common equity a number of characteristics. They are perpetual instruments, so they do not have a fixed maturity date. They do have an issue a call date and if not called subsequent issuer call dates, but no fixed maturity debt.
That's the first characteristic. In addition to that, they have discretionary coupon cancelation language, so that means that the issuer can decide to issue a coupon whenever it wants to do so. And then lastly, embedded in the eighty one structure is principal laws mechanism, and that means that if a certain capital trigger is hit that the part value of those instruments will either be written down temporarily or as was the case with the credit suis eighty one's
permanently all they are. They are converted into common.
Equity, so the eighty one one they're also known as contingent convertibles. They help banks comply with capital requirements as well, and they were created after the financial crisis as a way to imp losses on creditors without using taxpayer money, right, and that's how they kind.
Of that's the history, that's right, yes, yeah, yeah, Okay, So.
As you mentioned in the credit Swiss collapse that we saw earlier this year, the eighty one bonds were fully written down, which was I think a bit of a shock to some people and canceled by the Swiss authorities. How did this affect the eighty one market? Was their permanent damage?
Well, most of the eighty one prizal lines that we saw back in March have now been reversed. Having said that, over the past few months, eighty one's have been more or less range bound at around ten percent yield to worst for Euro and dollar denominated the bonds, so eighty one yields they've they've basically reset to a higher level if you compare it with where we were back in
January early February. This is mostly been due to higher rates rather than high spreads trading volumes in eighty one, so they have come down from the highs that we saw back in March. Some of this is probably due to the absence of eighty one issues between March and June. Some of it may also be due to seasonality over
the quieter summer months. But it may also be the case that some investors have decided to no longer be involved in the eighty one space given their volatility and the risk of impromptu rule changes by governments as we saw in Switzerland, and that may have heard demand technicals and liquidity, and may also have made eighty one prices potentially more volatile. But if you compare current trading levels with previous years, eighty one trading volumes actually don't look all.
That bad, so not really a huge impact then, I mean, the disappearance of this mass of institution credit Swiss. Other than a kind of a slap to the Swiss reputation for for you know, safe hands and you know solid banking, there hasn't really been that much long term impact on on on the market.
Well, you know, maybe it's too soon to say, but you know. I started that by saying that the reader cross between Switzerland and other jurisdictions is limited. The readacross between credit Swiss and other European banks is also limited. Valuations have recovered, Trading volumes are down, but not massively so, so you know, by the look of things, things have
normalized fairly quickly. But look, a precedent has been said, and I think some investors may have decided that, you know, this is just too wild a right and no longer wanted to be evolved in it.
But if you bought some of that stuff during the height of the panic earlier this year, you would have made a lot of money. Are there's still opportunities out there? Are they're still cheap eighty one bonds?
There are a few smaller issues, you know, issued by some smaller, more marginal banks that are trading at very wide levels, It's true. And then some of the Swiss Bank eighty one's I was away from ubs are also still trading at fairly wide levels. So I do think that there is a bit of a Swiss discount being applied to some of theirs. But some of those instruments, they are denominated in Swiss francs rather than in euros
or dollars. So away from that, yeah, I think the large majority of the of the eighty one space has has has recovered quite quite nicely.
Interesting, So let's talk about primary market issuance. You know, new debt sales in the US. The beginning of September, we kicked off with the busiest day in three years for primary high grade bond issuance. I mean that obviously includes debt of all types. But has the eighty one market also rebounded.
Yeah, So the primary market in eighty one's was shot between March and to June. That has now reopened. We've seen i think seven banks issue mostly in euros, and all the newly issued eighty ones they are trading around bar or a little above it. So perhaps that could also be taken as an indication that the dust has settled, that you know, invested nerves have steadied, and eighty one issuers have also become a bit more confident.
So let's talk about the calls your own the market has. According to Bloomberg News, there's about eighty four billion in notes that have calls over the next two years. Typically banks would call that debt and replace it with new debt, so that's you know, an issuance driver. But you've also noted non call risk. Can you talk a bit about the call and the non call risk and how that works.
Yeah, So, until recently, there's always been expectation in Europe that eighty one bombs would get called at the first call date. Back in twenty twenty we saw the first cases of bombs North getting called a first call date something there was the first one but then decided to call later on, and then you had Deutsche Bank and Lloyd's.
Since then, there have been a few others. In the fourth quarter of last year you had Rifis and Sabadel, but then Sabadel did a call later on, so there's been a few cases, had forth cases Going into this year, non core risks gone up because of the economics they've changed, you know, back end coopon reset indices, they have moved higher in line with higher rates, and as a result of that, you now have to be a bit more careful about this risk. You can no longer assume that
every single eighty one bond will get called. The first thing you have to look at is the starting capital position of an issuer. If a bank is well capitalized, you know, then they have got discretion to do as they please. If that is not the case, then a bank will need to issue a replacement bond, and if it does so, then you have to look at the core economics. So, in other words, the replacement bond at what level was it issued? Was it at the same level,
cheaper or more expensive? If the new bond was issued at a more expensive level, then there is a risk that the regulator will say, well, listen, you are you should not call the bond coming up for call. So the ECB has been a bit ambivalent on this topic. They have allowed some non economic calls. But very recently we saw something there not calling. It's five and a
quarter euro bones. That bond has its coming up for call actually at the end of this month, at the end of September, but the call notice period has now expired, and that in effect means that it will not get called. Something that had not issued replacement bond, and you know, because of its capital position, it meant that it was
not going to call. Was widely expected, so that it wasn't a huge surprise, but it does on the score the fact that this is this is a risk that investors need to consider carefully.
And even more uncertainty, which is maybe contribute fivoriting to the volatility and the liquidity issues that you mentioned earlier. That's right, yes, So let's look ahead, you run to the rest of the year and maybe into next year. What's next for the eighty one sector? What have you got your eye on?
So there's only one bond left for call this year, that's the Social Station General dollar seven and seven eighths callable in December. This particular bond will likely get called as it contains some legacy language. The bond was issued on the UK law, which is a bit of an
issue after Brexit. Looking into next year, there will be thirty three eighty one's coming up a first call across euro dollar and Sterling for an equivalent or thirty three billion dollars, and that is that's an increase on previous years. So you know, next year is shaping up to be quite quite a big big year for calls and probably also for issuance, and the year beyond twenty twenty five
is even larger. Now, over the past week, we've seen two banks doing a tender offer for one of their existing eighty ones with the first call date next year and simultaneously issue a new eighty one with a tender offer being contingent on the successful issue of the new bond. By the way, the two banks are in Tessa in
Italy and as the Group Bank in Austria. So that's that's a new way of replacing existing eighty one bonds coming up for call, which seems to be more efficient and so we think may well be adopted more broadly and.
More broadly in the sector your own. What else should we be looking for in European financials? You know, when when there was that big crisis with credits with some of the other band for kind of wobbling, Deutsche Bank was under a lot of stress. Are the other banks that we should be worried about? Are we expecting another replay of credits Swiss?
Well, you can never exclude that sort of stress scenario playing out. But what we do is every quarter we we have a close look at the at the balance sheet that the results of all the banks under our coverage. And you know, in the second quarter, as I mentioned earlier, banks by and large in Europe states pretty resilient in terms of their capital buffers in terms of their liquidity buffers, in terms of their asset quality, in terms of their profitability.
But you know within that sector that there is a you know, quite quite a variation between top and bottom names. Nothing screams as loudly as as credit squeeze, did, you know, in terms of deteriorating credits fundamentals. But you know there are some some names that do not have the same capital buffers as as as that appears, and equally equally liquidity and acid quality, you know, they do not all screen the same. So there is a degree of variation in that sector.
Absolutely, So certainly when we'll be looking up very closely as the European you know, economies come under more strained and you know global economic outlook is more tricky. But this is one we've got to watch. So thank you very much, your own U Liss of Bloomberg Intelligence. Thank you very much, and do read all of his great analysis on the Bloomberg Terminal and we hope see you back on the show soon.
Likewise, thank you, and.
Thanks again to Lisa Lee from Bloomberg News. Read all of her great credit scoops on the Terminal and at Bloomberg Dot com I'm James Crombie. It's been a plagure having you join us again next week on the Credit Edge