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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. This material does not constitute research.
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.
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