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When junior outperforms senior ‘AAA’

| June 28, 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.

Many CLO investors routinely overlook junior ‘AAA’ classes, but junior deserves a fresh set of eyes. Junior ‘AAA’ came 30 bp or more wide of senior ‘AAA’ in the heavy CLO trading of early June and continue to come similarly wide at new issue. The junior ‘AAA’ may not be as large or as liquid as its senior counterpart or offer as much spread as its subordinate siblings, but it brings a risk-return profile that should play well in properly scaled or leveraged portfolios.

Junior ‘AAA’ typically get carved out of a larger ‘AAA’ block to meet the needs of investors that wants ‘AAA’ exposure with more subordination. The junior comes out of the structure subordinate to the senior, with longer spread duration, smaller and arguably less liquid—all fair reasons, among others, to trade at a wider spread. The junior ‘AAA’ in NEUB 2018-30A, for example, came with 36 bp of added coupon and lately prices with 42 bp of added margin (Exhibit 1).

 Exhibit 1: An example of senior and junior ‘AAA’ CLO classes

Source: Amherst Pierpont Securities

Despite the diminutive, junior ‘AAA’ still have nearly the same credit protection as an untranched ‘AAA,’ making them correspondingly as remote from default and loss. The untranched ‘AAA’ from TFLAT 2018-1 has par subordination of 36.3%, not much more than NEUB 2018-30A’s 35.3% (Exhibit 2).

Exhibit 2: Untranched and junior ‘AAA’ have similar par subordination

Note: *Pays pro-rata with other ‘AAA.’ Source: Amherst Pierpont Securities

Investors appropriately note that a junior ‘AAA’ also might be more subject to downgrade than the senior. However, investors should also note that junior ‘AAA’ can trade surprisingly close to the spread on ‘AA’ CLO classes, limiting the price impact of the downgrade. And here’s where things get interesting.

Assuming for simplicity that LIBOR stays constant and the deal remains outstanding for five years, the wider spread on the junior ‘AAA’ steadily compounds to its advantage (Exhibit 3). At the end of Year 1, its cumulative compounded return advantage is 43 bp. At Year 2, it’s 90 bp. And by Year 5 it’s 251 bp. The junior ‘AAA’ builds up a rising lead in returns.

Exhibit 3: As junior ‘AAA’ spread compounds, price risk from downgrade falls

Note: analysis assumes constant LIBOR and that classes remain outstanding for five years. Price analysis also assumes a 1-time downgrade to ‘AA’ at the end of each indicated year. Source: Amherst Pierpont Securities.

The biggest risk to the junior ‘AAA’ performance comes in its earliest years when the spread duration of the class is the longest. If it gets downgraded to ‘AA’ at the end of Year 1 and widens to current spreads of 175 bp—only 10 bp wider than its current level—then the wider spread and the tranche’s spread duration of 5.28 years combine for a price loss of 53 bp. That more than offsets the junior ‘AAA’ spread advantage for a net cumulative loss of 10 bp. If the class gets downgraded at the end of Year 2, however, the tranche’s spread duration is only 4.28 years and the price loss is 43 bp. That still leaves 47 bp of excess return by the end of that year. And in future years, the potential excess return of the junior ‘AAA’ gets larger.

Of course, downgrades do not have to stop at one rating level, and more severe downgrades or wider spreads on ‘AA’ could further offset the compounded return of the junior ‘AAA’ spread.

Across different managers and structures and underlying portfolio strategies, the spread between senior and junior ‘AAA’ and the spread between junior ‘AAA’ and ‘AA’ will differ. Durations will differ, too. All of these will change the compounded advantage of junior ‘AAA’ and the timing and price impact of downgrade. But the broader point is that junior ‘AAA’ seem to offer substantial return for the risk taken.

For investors looking to make their mark by building up diversified portfolios of junior ‘AAA’ or using the favorable financing often available to ‘AAA’ assets, the potential to outperform peers holding other forms of ‘AAA’ CLO risk seems clear.

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jkillian@apsec.com
john.killian@santander.us 1 (646) 776-7714

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