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An easy Fed lifts the outlook for CLOs

admin | July 25, 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. This material does not constitute research.

CLO debt this year has lagged the spread tightening in almost all rating levels of corporate debt, most likely out of concern about slowing growth. The most leveraged balance sheets, after all, do take the first hit as growth slows. But the Fed’s new dovishness may turn the trend around. If history is any guide, easy financial conditions could persist for years and give all balance sheets, especially leveraged ones, important support. And wide spreads on CLOs make the sector an attractive way to play an easy Fed.

Anticipating an easy Fed

Although the Fed frequently changes the timing and magnitude of interest rate moves, it much less frequently changes the direction of rates. Since the Fed started releasing FOMC statements in 1994, the Fed has moved rates 68 times but only changed the direction of rates eight times (Exhibit 1). A Fed cut in July would mark the ninth change. The shortest interval from initial cut to eventual hike or vice versa was nine months in 1998-1999, the longest interval was 8.25 years in 2007-2015, and the average has been 2.83 years. The Fed is prone to swirl the tea leaves of inflation and employment for quite a while before changing direction. If history is a guide, a Fed that cuts in July may not tighten for years.

Exhibit 1: Th Fed often goes for long stretches before changing policy bias

Source: Bloomberg, Amherst Pierpont Securities

Sustained easy conditions helps borrowers, especially leveraged ones, both through falling absolute levels of rates and often, but not always, tighter spreads. Falling rates obviously lower the cost of debt, something that would have an immediate impact on borrowers with floating-rate leveraged loans. Lower rates also encourage investors to look for yield in riskier assets, at least as long as recession does not seem imminent. Consensus sees US growth slowing toward 2% with no imminent recession.

CLOs have lagged far behind corporate debt

Spreads on CLOs this year have lagged corporate debt, leaving the yield spread between CLOs and corporate debt noticeably wide. Over the last year, ‘AAA’ CLOs and ‘AAA’ corporates have traded at a tighter spread than the current 61 bp 70% of the time (Exhibit 2). ‘AA’ CLOs and ‘AA’ corporates have traded tighter than the current 116 bp 93% of the time. ‘A’ CLOs and ‘A’ corporates have traded inside the current 151 bp spread 90% of the time, and ‘BBB’ CLOs and ‘BBB’ corporates have traded inside the current 200 bp spread 91% of the time. Even in ‘BB’ paper, the CLO-to-corporate spread has run tighter than the current 425 bp 78% of the time.

Exhibit 2: The spread between like-rated CLO and corporate debt is wide

Note: Percentiles represent the percentage of trading sessions over the relevant time period where spreads have been tighter than their current value. Source: CLO DMs from Palmer Square Capital Management, CLO DMs from Palmer Square Capital Management, Amherst Pierpont Securities calculations.

The wide spread between CLO and corporate debt largely reflects the strong performance in corporates, especially ‘AA’ and ‘A’ (Exhibit 3). Option-adjusted spreads on the average ‘AAA’ issuer, at 61 bp, have traded tighter in the last year only 28% of the time. Spreads on the average ‘AA’ issuer, at 63 bp, have traded tighter only 5% of the time, and spreads on the average ‘A’ issuer, at 91 bp, have traded tighter only 12% of the time. The standout performance of ‘AA’ and ‘A’ debt reflects scarcity and liquidity.  ‘BBB’ debt, at 153 bp, has traded tighter 33% of the time. And ‘BB’ and ‘B’ debt has traded tighter around half the time. High yield has clearly underperformed investment grade, again likely out of concern about slowing growth.

Exhibit 3: Corporate debt trades at some of the tightest spreads in recent years

Note: Percentiles represent the percentage of trading sessions over the relevant time period where spreads have been tighter than their current value. Source: ICE BoAML US Corporate and High Yield Option-Adjusted Spreads, Amherst Pierpont Securities Calculations.

CLO debt, meanwhile, has lagged in both investment grade and high yield categories. CLO ‘AAA’ debt, at a current benchmark discount margin of 120 bp, has traded tighter in the last year 44% of the time (Exhibit 4). CLO ‘AA’ debt, at 177 bp, has traded tighter 58% of the time, ‘A’ debt, at 243 bp, has traded tighter 63% of the time and ‘BBB’ debt, at 352 bp, has traded tighter 60% of the time.  The speculative grade ‘BB’ debt, at 670 bp, has traded tighter 66% of the time.In general, CLOs are trading tighter than usual in ‘AAA’ classes and wider than usual everywhere else.

Exhibit 4: CLO debt trades at or wide of median spreads in recent years

Note: Percentiles represent the percentage of trading sessions over the relevant time period where spreads have been tighter than their current value. Source: CLO DMs from Palmer Square Capital Management, Amherst Pierpont Securities calculations.

CLOs hampered by wider spreads on leveraged loans

Wider spreads in leveraged loans may be hampering CLO debt. The margin on leveraged loans now stands near its widest levels of the year (Exhibit 5). High yield corporate debt shows roughly the same pattern, so some combination of supply, demand and credit fundamentals have left spreads soft across speculative grade loans and bonds. Wider loans spreads, however, allow new CLO managers to potentially issue deals at wider spreads and still realize good potential return. The risk of new CLO debt at wider spreads limits the ability of existing debt to tighten.

Exhibit 5: Margins on leveraged loans backing CLOs trade near their widest levels of 2019

Note: S&P/LSTA US Leveraged Loan 100 B/BB Rating Index Weighted Average Yield net of 1- and 3-month LIBOR. Source: S&P/LSTA, Bloomberg.

Wider spreads on both leveraged loans and high yield debt arguably reflect market concern about slowing economic growth and its impact on leveraged balance sheets.

It is also possible that the market is penalizing CLOs for their relatively lower liquidity. The $617 billion in outstanding CLOs has a smaller audience than the more than $6 trillion in corporate debt securities. This could explain the underperformance in CLOs even to high yield corporate debt.

Other possible explanations of CLO underperformance seem less likely:

• An oversupply of CLOs and an undersupply of corporate debt do not appear to be the case. Issuance of new CLOs is down from 2018 year-to-date by 10%, issuance of new investment grade corporate debt is down 13% and high yield is up 20%.
• Expectation of more call risk in CLO debt also seems an unlikely explanation. With soft spreads on CLO debt, call risk, if anything, has declined.

Implications of Fed policy

The Fed’s clear intent to lower rates and keep financial conditions easy should help leveraged loans and high yield bonds. Debt service clearly gets easier under those conditions and lower rates and should prompt investor interest in any assets with higher yield.

The market has priced Fed cuts through the end of this year, and it seems highly likely that the Fed will then wait at least through 2020, even if the economy somewhat exceeded expectations, before tightening policy. Since the Fed historically shifts the direction of rates infrequently, the Fed could stay accommodative even longer.

Fixed income investors likely have at least 18 months of runway in front of them where financial conditions should narrow the gap between CLOs and corporate debt, especially in investment grade classes. Higher yield and potential tightening would compound to the advantage of the CLO. This looks like a fair entry point.