The elusive hunt for a good CLO hedge
admin | August 2, 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.
Persistent wide spreads between CLOs and similarly rated corporate debt usually gets chalked up to some mix of differences in liquidity, fundamental credit risk or supply and demand. But another factor, hedging, should join the mix. Hedging CLOs is harder than hedging corporate debt or most other parts of fixed income, and investors should get something for taking the risk.
Low correlation with daily changes in CLO spreads
It is difficult to find market indices much less tradeable instruments that seem like strong hedges for CLOs. The challenge is not hedging interest rate risk since CLO coupons float with the changing fair market value of the coupon index, usually 3-month LIBOR. The challenge is hedging the changing fair market value of the margin or spread over LIBOR. Changes in liquidity preferences, fundamental credit or supply and demand affect the spread. As the market’s view of the fair spread changes, so does the price of CLO debt.
Candidates for hedging CLO debt seem straightforward:
- Leveraged loan indices or related ETFs that reflect the changing value of the loans backing CLOs
- Investment grade or high yield corporate debt or credit default swaps that reflect broader market views of corporate credit and liquidity
- Instruments reflecting macro influences such as volatility, broad market liquidity preferences or funding pressures, or
- The slope of the yield curve, reflecting market expectations for the Fed, interest rates and the economy
A study of the last five years of daily changes in spreads on CLO ‘AAA’ to ‘BB’ shows relatively low correlation with daily changes almost all of these measures (Exhibit 1). Outside of modest correlation with spreads on other CLO debt, only one of 55 correlations with other plausible market indicators exceeded 0.20. That single correlation, between daily changes in CLO ‘BB’ debt spreads and daily total returns on the S&P/LSTA leveraged loan index, only rose to 0.24.
Exhibit 1: CLO debt spreads show low correlation to possible market hedges
Note: correlations between session-to-session changes from 9/30/15-6/19/19. N=903. Source: Bloomberg, Amherst Pierpont Securities.
Combining several hedges still comes up short
Sometimes several potential hedges with low individual correlation to asset performance can add up to a more effective combined hedge, but that, too, seems elusive with CLO debt. Regressing the daily change in CLO ‘AAA’ discount margin on daily changes in investment grade corporate cash spreads, investment grade CDS, high yield corporate cash spreads and daily returns on the S&P/LSTA leveraged loan index showed an R-square of only 0.05, suggesting potential reduction in daily volatility of the ‘AAA’ P&L of only 5% (Exhibit 2).
Exhibit 2: Combining several possible hedges trims daily CLO ‘AAA’ P&L slightly
Source: Amherst Pierpont Securities
Low correlation between daily CLO spread changes and potential hedges still likely means higher correlation over longer periods—week-to-week or month-to-month, for example. But that still requires an appetite for daily CLO spread volatility on the expectation that over the longer haul things work out.
The difficulty of hedging CLOs means mark-to-market portfolios have to bear most of the daily volatility of CLO spreads. That likely translates into a higher cost of capital for mark-to-market positions and, for market makers, less appetite for committing capital to positions, especially in stressed markets. For these reasons at least, a good hedge would go a long way toward tightening CLO spreads.
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