As ‘AAA’ goes, so goes the capital stack
admin | February 8, 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.
Take the names of some CLO managers, add in the levels where their ‘AAA’ debt prices and you may know most of what you need to figure out spread on the rest of their deals. CLO pricing can seem so easy.
The spread where a CLO prices at all rating levels clearly depends on the CLO manager. Take ‘AAA’ for example. If you take a set of managers issuing in the market under similar market conditions, some managers tend to price tighter than others and some price wider. To compare managers over different markets where average spreads might vary significantly, it helps to create a standardized score or Z-score for each market and then use the average manager Z-score. The average manager Z-score in just ‘AAA’ varies significantly (Exhibit 1). Some managers price at negative Z-scores, representing spreads tighter than average, and some price at positive Z-scores, representing spreads wider than average.
Exhibit 1: Broad dispersion in where CLO managers price ‘AAA’ debt
Note: data reflect the result of taking the distribution of ‘AAA’ CLO new issue debt spreads over short periods of time and calculating a separate standardized Z-score for each deal for each manager. For managers with more than one deal, the average Z-score is weighted by the size of each deal. The analysis uses new issue CLO spreads since 2011 to produce Z-scores for 98 CLO managers. Source: Amherst Pierpont Securities.
The average manager Z-score for ‘AAA’ CLO debt turns out to go a long way toward predicting the same score for ‘AA’ (Exhibit 2). And the score for ‘AA’ goes a long way to predicting ‘A’. And so on down the capital structure. Using new issue CLO pricing data from 2011 through 2018, the score at each rating level correlates with the score at the next lower level at around 0.80. That means that the spread on the ‘AAA’ explains roughly 70% of the variance in the spread on ‘AA’ and so on down.
Exhibit 2: The average CLO manager Z-score at each rating level correlates highly with the score the next rating level down
Source: Amherst Pierpont Securities
The reasons for the persistent ordering of managers across different rating classes could vary. It could reflect persistent differences in the breadth of buyers, secondary market liquidity, quality of the managers asset portfolios or performance results. It clearly creates persistent differences in the cost of debt capital for the managers.
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