A unique role for CLOs
admin | July 17, 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.
CLOs may have a unique role to play in a market with rates near zero, a steepening yield curve and broadly tightening spreads. Relatively high CLO margins add yield, floating coupons limit interest rate risk and moderately long average lives create enough spread duration to capitalize on tightening. The clear risk is exposure to the underlying leveraged loans, which could see historic defaults in a prolonged recession. But investment grade CLO debt from well chosen managers should largely mitigate that risk, and current pricing on ‘AAA’ debt in particular creates a good entry point.
The value of spread exposure
Fed QE has made spread exposure particularly valuable and should keep it valuable well into 2021 if not beyond. In the first quarter of the year, differences in spread duration had a significant impact on relative asset returns. By committing to buying $80 billion a month in Treasury debt and adding $40 billion a month in agency MBS, the Fed is slowly reducing the supply of relatively safe and liquid assets. The Fed’s ability to buy up to $750 billion in investment grade corporate debt through the Primary Market Corporate Credit Facility and the Secondary Market Corporate Credit Facility adds to the potential shortfall in supply. Beyond stabilizing the targeted markets, the Fed programs force investors into neighboring riskier assets, tightening spreads broadly in the process.
Investors have a wide set of choices for adding spread duration and capitalizing on the tightening, but most choices lose some of their appeal in light of low rates or a steepening curve. Investors can find plenty of floating-rate assets with long average lives—agency CMO floaters, as one example—but often without the yield of CLOs. Investors can also find plenty of fixed-rate assets with higher yields—long CMBS or some 30-year mortgage pass-throughs or corporate debt, for example—but most bring exposure to the 10-year and longer parts of the curve likely to get hurt when the economy eventually gets traction and the curve steepens.
A good deal depends on working with the right managers
Leveraged loans do have outsized exposure to any sustained recession, but stress testing by the NAIC and S&P, among others, show ‘AA’ and ‘AAA’ CLO classes robust to losses. Of course, even the most highly rated classes should widen if lower rated classes in the same structure get downgraded. But that’s where choice of manager can help. Even through Moody’s from January through mid-June had put 25% of CLO classes on CreditWatch Negative and downgraded 5%, nearly a third of managers had no rating actions taken (see Ranking CLO managers by rating actions). That included several managers with long-standing records of strong portfolio performance including AEGON, Blackrock and Palmer Square, among others. A portfolio of good managers should limit the risk of downgrades in other classes in a deal.
A good entry point in CLO ‘AAA’ debt
CLO ‘AAA’ debt lately has widened to fair value, creating a good entry point for investors. The average spread on securities traded in the secondary market from June 12 to July 16 has run from 169 to 181 (Exhibit 1). Estimated fair value for ‘AAA’ debt—using a model of CLO spreads that considers rating, structure, loan attributes, general market conditions and manager—meanwhile has tightened from 159 to 153. The gap between secondary market spread and fair value consequently has widened from June’s 10 bp to July’s 28 bp.
Exhibit 1: After tightening to fair value into June, CLO ‘AAA’ has widened again
Other benchmarks also show CLO ‘AAA’ debt as wide. The Palmer Square index of CLO ‘AAA’ spreads between June 12 and July 16 has run roughly unchanged at 168 bp. Spreads on conduit CMBS ‘AAA’ classes meanwhile has tightened from 125 bp to 115 bp, widening the spread between the sectors from 43 bp to 53 bp, not far from the widest point of the year (Exhibit 2). In fact, over the last five years, CLO ‘AAA’ debt has traded wider than 53 bp against CMBS only 7% of the time.
Exhibit 2: CLO ‘AAA’ has also widened to CMBS ‘AAA’
The widening of CLO ‘AAA’ to fair value and other benchmarks is puzzling, especially against CMBS. CMBS is sensitive to the value of commercial real estate largely set by the ability and willingness of corporate tenants to make rent payments. The value of CLOs obviously depends on the ability and willingness of corporate borrowers to make payments. There may be a difference in the ratings of CMBS tenants and CLO borrowers, but many CMBS tenants are small and unrated.
One possible explanation of the underperformance lately in ‘AAA’ is the relatively heavy BWIC activity in June. Activity peaked at $7.2 billion on June 19 in the heaviest month of volume since April (Exhibit 3). The volume may have weighed on the sector.
Exhibit 3: June saw relatively heavy CLO ‘AAA’ BWIC volume
Other investment grade CLO debt looks fair to rich
Other investment grade classes of CLO debt look like fair value or rich to fair value. ‘AA’ debt looks roughly fair value, based on Amherst Pierpont models, while ‘A’ and ‘BBB’ debt look rich (Exhibit 4)
Exhibit 4: Other investment grade CLO debt looks fair to rich
Good prospects for investment grade debt
Investment grade debt should continue performing well as long as Fed QE and other programs continue to draw down the supply of safe debt. Balancing exposure to the right credits against the need for yield and the risk of higher long rates is a challenge. The right class and the right managers could make CLOs a useful solution.