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A challenge from lagging spreads

admin | September 27, 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.

CLOs have had a tough time in recent years keeping up with spreads on most competing corporate and structured products, with the gap generally widening with each step down in rating. Wider leveraged loan spreads have weighed on CLOs and look likely to continue adding drag until US growth stabilizes. The issue: slowly weakening loan fundamentals.

Weaker performance at lower ratings

Against corporate debt, CLOs have generally widened in every rating category. ‘AAA’ CLOs, for instance, have widened against corporates since September 2017 by 27 bp, since September 2018 by 5 bp and only tightened a few basis points this year (Exhibit 1). The widening has been more pronounced with each drop in rating. Toward the lower end of the ratings scale, for instance, ‘BB’ CLOs have widened against corporates since September 2017 by 146 bp, since September 2018 by 189 bp and have continued lagging substantially this year. Although some of the widening could reflect changing preference for fixed corporate debt rather than floating CLOs, the sharper widening at lower ratings suggests concern about leveraged loan credit in particular.

Exhibit 1: CLOs generally have widened against corporate debt

Source: ICE BofAML US Corporate and High Yield OAS, Palmer Square Indices, Amherst Pierpont Securities. A time series of spreads between CLOs and corporate debt is available here.

Against CMBS, CLOs spreads have also generally lagged with lower ratings turning in weaker performance. ‘AAA’ CLOs have widened to CMBS since late 2017 by 27 bp although tightening by single digits more recently (Exhibit 2). At lower ratings, CLOs have widened sharply since September 2017 and have largely continued widening this year. The widening could reflect shifting preference for interest rate exposure, but concern about leveraged loan credit seems likely.

Exhibit 2: CLOs have generally lagged private CMBS

Source: Palmer Square Indices, Amherst Pierpont Securities. A time series of spreads between CLOs and corporate debt is available here.

CLOs have lagged ABS over longer horizons, tightened in the first half of this year and widened again since June (Exhibit 3).  The choice of a best ABS benchmark is more difficult, but credit card ABS offers a reasonable floating-rate comparison. ‘AAA’ CLOs have lagged similarly rated 7-year credit cards. In lower rating categories, CLOs have generally lagged credit cards by even more.

Exhibit 3: CLOs have generally lagged credit card ABS

Source: Palmer Square Indices, Amherst Pierpont Securities. A time series of spreads between CLOs and corporate debt is available here.

Wider spreads in leveraged loans

The path of spreads in CLOs has roughly tracked spreads in leveraged loans: tightening briefly in late 2017, widening through 2018, tightening again in early 2019 and then running sideways since (Exhibit 4). Loan spreads broadly drive CLO spreads. At wide loan spreads, CLO managers can print viable deals with wide liabilities and drive secondary spreads wider, too. And at tight loan spreads, tight new issue CLO liabilities help tighten secondary spreads.

Exhibit 4: The average B+/B loan has widened over the last few years

Source: S&P LCD, Amherst Pierpont Securities

A couple of factors have arguably contributed to widening in leveraged loans and still have momentum:

• Rising debt multiples. Leveraged borrowers are taking on more debt. The share of large corporate leveraged loans with a ratio of debt-to-EBITDA of 4x or greater—often the dividing line between ‘BB-‘ and ‘B+’ credit—a has run from 78% in 2017 to 93% in the second half of 2019. Strong equity markets continue to encourage the M&A and LBO activity that contributes the bulk of the most highly leveraged loans.
• Falling cash flow multiples. Leveraged borrowers also have less income to cover interest expenses. The ratio of EBIDA-to-cash-interest has dropped from 3.55x in 2017 to 3.03x in the second half of 2019, although lower interest rates since May have almost surely cut interest expense
• A high share of covenant-lite loans. The cov-lite share of new loans this year is running between 70% and 80%, and the most recent work on recoveries suggests that post-crisis cov-lite loans have had recoveries roughly 10 percentage points below historic levels.
• Other risks. The share of M&A transactions that rely on cost savings to hit financial targets has jumped from 58% in 2017 to 70% this year. Borrowers continue to explore the ability to take out marginal loans secured by the same collateral posted against the term loans owned by CLOs.

All of these issues raise risk in leveraged loans as the economy slows, and they stand to keep pressure on leveraged loan spreads until the economy shows some stability.

Spread performance is only one part of CLO total return, of course, and the generally higher yield and lower interest rate sensitivity of CLOs along with relatively low correlation to other fixed income assets still earn CLOs a place in most portfolios. Spreads, however, may not add much for now to returns.