The UK and Europe debt (structured finance) fund, TwentyFour Income (TFIF), released its annual results to 31 March 2020. The NAV was down (12%) in total return terms, over the financial year. We note that as at 21 July, TFIF’s shares were down by about (8.4%) over the year-to-date – they have recovered most of their March falls. The financial year-end coincided with the March sell-off.
TFIF’s chairman, Trevor Ash, reflected on the year: “The NAV performance of the company has varied during the year. It was broadly positive during the first three months as European ABS spread performance caught up with corporate credit after a slow start to 2019, before some weakness was felt during August and September 2019, though prices rebounded strongly into the end of the year. However this has been completely overshadowed by the volatility felt across all financial markets since late February, as a result of the implications of a global shutdown in response to the COVID-19 pandemic. Fundamental performance of the asset pools and structures remained strong and stable at the period end, and ratings remained stable. However, a global recession is now expected and this will lead to an increase in arrears and loan defaults generally in both consumer and corporate lending markets, as well as a current increase in bonds being put on review for downgrade, which will likely lead to an increase in credit ratings downgrades in future. As an indication of the size of the move in spreads during the COVID market disruption, I understand that single-B rated CLOs, which are very much at the most volatile end of the Company’s holdings, widened from a spread of 795 basis points to over 2,000 basis points. They have since recovered to around 1,200 basis points. The impact of these kind of movements was a 20% reduction in the Company’s NAV, with a subsequent ongoing recovery.
As a result of the market moves seen at the end of the financial year, spreads in European ABS are now wider than they have generally been since the company was launched. While underlying performance of the sector is expected to deteriorate, the dislocation between the performance implied by current pricing and what is expected means that the current opportunity set has become as, or more, interesting than it has been during the life of the company. This will allow for additional capital to be issued should investor appetite demand it.”
Market outlook – ABS market to be driven by consumer spending
We also include an outlook statement from TFIF’s manager: “The outlook is currently solely driven by the development of COVID-19 pandemic, which is likely to result in a global recession. The extent of the impact will be driven by the length of the global lockdown and the longevity of the impact of the economy. Specifically for the ABS market the impact on fundamental performance will be driven on the consumer side by obvious factors such as unemployment rates, but also by the extent to which lenders permit forbearance to distressed borrowers. It is worth noting that while headlines have made it clear lenders are being encouraged to offer forbearance, this has typically been lender policy anyway and is normally the first step in an arrears management process. This results in a deferral of interest payments rather than the permanent loss of interest or a default. It is for this reason that liquidity and general reserves are structured into ABS deals.
Historically, in terms of corporate borrower risks, largely via allocation to CLOs, we have stress-tested transactions based on a dual approach of a severe recessionary scenario and assessing the level of underlying defaults that each tranche can withstand. As a result of the COVID-19 pandemic we have added a scenario that more specifically targets underperformance in sectors more directly impacted, including retail, tourism, and transport, among others. The modelling output points encouragingly towards the worst case scenarios being interest deferral on a limited number of exposures within the portfolio, with such interest accruing and subsequently being paid in full with all principal also repaid. We do expect to see the leveraged loan market experience a material increase in CCC ratings, downgrades, which will hurt CLO equity, and likely keep CLO spreads wider for longer.
While we are currently seeing an increase in primary market activity, these are largely transactions postponed as a result of the recent market closure, and we expect supply to be materially lower than in recent years during the second half of the year. This is as a result of lower loan origination volumes in consumer lending, and also as the cost of incubating CLOs on bank balance sheet should become more expensive and harder to source. This lack of supply could support prices over a medium-term timeframe. However, should market sentiment become driven by either extension or gradual release from lockdown, we would expect that to be a more immediate driver of ABS pricing. In addition it should be expected that there will be ratings downgrades as economic performance weakens.
Although coming into 2020 positioned for a degree of market volatility, the Company was not positioned for the unforeseeable arrival of COVID-19 and its effect on financial markets everywhere. As such, whilst benefiting to an extent from the portfolio’s lower risk position, like most in the sector, the company was exposed to the ensuing price volatility. However, the opportunity set as it currently exists is extremely attractive, and lagging performance seen in other parts of fixed income. In markets such as those seen recently, the closed-ended structure allows optimal support for the strategy to access strong credits which we believe to be currently fundamentally mispriced.”
TFIF: Annual results and a CLO market outlook from TwentyFour Income