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A simple model of CLO spread-per-turn-of-leverage

| January 18, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Even though nominal spreads on all CLO debt tend to widen as leveraged loan prices fall, not all classes feel the pain equally. Lower-rated and more leveraged classes take the brunt, with the market demanding spread for every rising turn of leverage. But after accounting for leverage, the more subtle influence of other factors becomes clearer. CLO price, callability and reinvestment window, among other things, step to the fore.

Just another day in the CLO markets

The market seems to demand surprisingly consistent spread-per-turn-of-leverage, or SPTL, in CLO classes over time (Measuring relative value through spread-per-turn-of-leverage), but it also seems to demand consistent spread across different offerings at a given point in time. A given day’s offerings across and within CLO rating categories can show a wide nominal range but a limited range of spread-per-turn-of-leverage. At least 47 CLO debt classes from ‘AAA’ to ‘BB’ showed up in the market on January 15, for instance, with indicated nominal discount margins ranging from 111 bp to 744 bp. But SPTL across these offerings only ranged from 26 bp to 49 bp.

Exhibit 1: A wide range of nominal spreads, a narrow range of spread-per-turn-of-leverage

Source: APS

The tendency for SPTL to explain a large part of the range in nominal spread across and within rating categories immediately raises the possibility that it evens the playing field for finding relative value across CLO debt. Before drawing that conclusion, however, it’s worth seeing if some of the differences in SPTL reflect other features of a CLO offering—like time-to-first-call-date and time-to-last-reinvestment-date.

Tighter spreads for longer non-call periods

The time to a CLO’s first call date should influence spreads – both nominal and SPTL. The time-to-first-call signals how long an investor potentially has hold onto a premium coupon before the equity class exercises its call option, refinances or restructures the debt. That’s the option the debt investor writes to the equity class, struck at the discount margin at new issue. The shorter the non-call period, the more valuable the equity holder’s option and the more yield premium or spread the CLO debt investor should get. Focusing just on the largest category of CLOs in the market on January 15, the ‘AA’ classes, SPTL declines a few basis points as the non-call period available across securities gets longer (Exhibit 2).

Exhibit 2: Even in a 1-day snapshot, SPTL for secondary ‘AA’ securities rises slightly as the CLO non-call period gets shorter

Note: data show SPTL on 1/15/19 for secondard ‘AA’ CLO classes. Source: APS

Wider spreads for longer reinvestment periods

The time to last reinvestment date also should matter, at least for today’s par-to-discount securities, because the CLO has more spread duration and, consequently, should offer more compensation. Again for the ‘AA’ classes in the market on January 15, that’s the case. Spreads widen slightly for every year remaining in reinvestment (Exhibit 3).

Exhibit 3: SPTL across ‘AA’ securities rises slightly as reinvestment period gets longer

Note: data show SPTL on 1/15/19 for secondary ‘AA’ CLO classes. Source: APS

Measuring the impact in basis points

Any single day’s trading activity is not a reliable guide to the market over time, but it does put to the test the idea that the market incorporates these factors into its bid. A simple regression across the ‘AA’ secondary flows shows that for every additional year of non-call protection, SPTL declines by 3.0 bp. For every additional year before the end of reinvestment, SPTL rises by 1.3 bp. (Exhibit 4). And both effects are statistically significant.

Exhibit 4: Regressing SPTL on Years-to-first-call and Years-to-last-reinvestment indicates both significantly affect spreads

Source: APS

More work to do

The manager, liquidity and other factors also likely weigh into market spreads. But the finding that even a single day’s secondary activity significantly reflects the influence of non-call and reinvestment periods bodes well for efforts to model spreads and estimate fair value. And once we know fair value, better value should be even clearer.

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