Picking up spread, adding better managers as refis roll
admin | February 21, 2020
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.
Spreads in the CLO market have tightened and the spread curve has steepened in the last few months, helping trigger the highest volume of refinancing in at least two years. Debt investors trying to outperform peers can take advantage of the market to add yield by trading into newly callable debt trading at modest premiums. The heavy refinancing also opens the door to reallocating to better managers.
The CLO spread curve has tightened and steepened over the last six months. An appetite for risk and a rally in ‘B/B+’ loans has driven tighter spreads in CLO liabilities. An inverted LIBOR curve has also increased demand for shorter CLO paper, steepening the spread curve. The ‘AAA’ spreads tightened on average 10 bp from the first half to the second half of the preceding year (Exhibit 1). In particular, spreads of ‘AAA’ securities with the shortest WAL tightened as much as 17 bp, whereas the spreads of ‘AAA’ securities with the longest WAL tightened by only 6 bp.
Exhibit 1: CLO ‘AAA’ spread curve tightened and steepened since August 2019 compared to the six months prior to August 2019
Source: Amherst Pierpont Securities. Note: This analysis groups ‘AAA’ bonds on BWICs within each time frame by their WAL rounded to the nearest year then averages their spreads to plot the trend above.
More than 63.7% of outstanding AAA CLO debt now offers a coupon higher than current market rates. And the volume of AAA premium callable debt should rise from $108.5 billion currently to $121.2 billion in the next three months as 2018 issuance comes out of its non-call period. Issuers need to consider other factors before refinancing, however. There are transaction costs, of course. The time left in the reinvestment period also determines potential savings and the possibility of even tighter spreads affects timing. Nevertheless, refinancing in February 2020 has jumped to the highest level in at least two years (Exhibit 2).
Exhibit 2: US CLO refinancing volume reaches a 2-year high at $6.5B
Source: S&P, Amherst Pierpont Securities.
Investors can take advantage of spread volatility by buying CLO debt trading at modest premiums with longer average lives. The equity class holds the option to refinance, but the possibility of even tighter spreads makes the decision to exercise complex. With benchmark 3-year ‘AAA’ spreads now at 113 bp, newly callable debt with coupons around 128 bp are arguably right at the money on the option to refinance—high enough to make it interesting, but not high enough to compel immediate action. The decision gets complicated further if the market value of the collateral has dropped. In that case, the value of equity has dropped well below new-issue levels, and equity may have to add cash to the deal before trying to distribute refinanced debt at current market levels. Investors can hold these modest premium priced classes and likely collect coupon longer than buying more in-the-money debt.
Investors can also use the wave of refinancing to re-allocate into better managers. Managers with enough scale, the right mix of collateral and enough liquidity to adapt to changing markets did well in 2019. These managers continue to look like good allocations in 2020.
This material is intended only for institutional investors and does not carry all of the independence and disclosure standards of retail debt research reports. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.
This message, including any attachments or links contained herein, is subject to important disclaimers, conditions, and disclosures regarding Electronic Communications, which you can find at https://portfolio-strategy.apsec.com/sancap-disclaimers-and-disclosures.
Copyright © 2023 Santander US Capital Markets LLC and its affiliates (“SCM”). All rights reserved. SCM is a member of FINRA and SIPC. This material is intended for limited distribution to institutions only and is not publicly available. Any unauthorized use or disclosure is prohibited.
In making this material available, SCM (i) is not providing any advice to the recipient, including, without limitation, any advice as to investment, legal, accounting, tax and financial matters, (ii) is not acting as an advisor or fiduciary in respect of the recipient, (iii) is not making any predictions or projections and (iv) intends that any recipient to which SCM has provided this material is an “institutional investor” (as defined under applicable law and regulation, including FINRA Rule 4512 and that this material will not be disseminated, in whole or part, to any third party by the recipient.
The author of this material is an economist, desk strategist or trader. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM or any of its affiliates may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.
This material (i) has been prepared for information purposes only and does not constitute a solicitation or an offer to buy or sell any securities, related investments or other financial instruments, (ii) is neither research, a “research report” as commonly understood under the securities laws and regulations promulgated thereunder nor the product of a research department, (iii) or parts thereof may have been obtained from various sources, the reliability of which has not been verified and cannot be guaranteed by SCM, (iv) should not be reproduced or disclosed to any other person, without SCM’s prior consent and (v) is not intended for distribution in any jurisdiction in which its distribution would be prohibited.
In connection with this material, SCM (i) makes no representation or warranties as to the appropriateness or reliance for use in any transaction or as to the permissibility or legality of any financial instrument in any jurisdiction, (ii) believes the information in this material to be reliable, has not independently verified such information and makes no representation, express or implied, with regard to the accuracy or completeness of such information, (iii) accepts no responsibility or liability as to any reliance placed, or investment decision made, on the basis of such information by the recipient and (iv) does not undertake, and disclaims any duty to undertake, to update or to revise the information contained in this material.
Unless otherwise stated, the views, opinions, forecasts, valuations, or estimates contained in this material are those solely of the author, as of the date of publication of this material, and are subject to change without notice. The recipient of this material should make an independent evaluation of this information and make such other investigations as the recipient considers necessary (including obtaining independent financial advice), before transacting in any financial market or instrument discussed in or related to this material.