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‘A’ classes lead debt returns through July

| July 31, 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.

So far this year, CLO ‘A’ debt has led the way among CLO classes in both absolute returns and in return for risk taken. CLO ‘AAA’ and ‘AA’ debt showed much lower absolute and risk-adjusted returns, and ‘BBB’ and ‘BB’ debt on average has lost money through July. For the balance of the year, ‘AAA’ debt still looks like it has the best prospects.

An investor that put $1 in an ‘A’ class in January had $1.0042 at the end of July, based on estimates from the Palmer Square indices. It was a nail-biting path to even that slim return, however. Returns on ‘A’ debt went negative in March before rebounding afterwards (Exhibit 1). Lower-rated classes began falling sooner, as early as late January for ‘BB’ and late February for ‘BBB’. Returns on ‘AAA’ through ‘A’ classes started falling in mid-March. Lower-rated classes also underwent the most cumulative losses, as high as -37.4% at the bottom of the trough for ‘BB’.

Exhibit 1: Returns on CLO debt classes dipped low in March then slowly

Source: Palmer Square, Bloomberg, Amherst Pierpont Securities

Overall, ‘A’ debt returned an annualized 1.23% through July with an annualized standard deviation of 9.87%, or a return of 12.5 bp for each 1% of risk (Exhibit 2). ‘AAA’ debt returned an annualized 0.30% with an annualized volatility of 5.13%, and ‘AA’ debt returned 0.35% with a volatility of 9.00%. ‘BBB’ and ‘BB’ debt showed negative returns of -0.79% and -8.84%, respectively, with annualized risk higher than 20%. The risk-adjusted return for ‘A’ debt leads the other debt classes.

Exhibit 2: CLO annualized returns, volatility, and risk-adjusted returns by debt class

Source: Palmer Square, Bloomberg, Amherst Pierpont Securities.

A potential reason why ‘A’ class has had strong risk-adjusted return this year to date is its trading rich to fair value since March (Exhibit 3). In comparison, the ‘AAA’ class has traded below fair value. The ‘AAA’ secondary spread has widened again since mid-May, after tightening to its fair value. The CLO ‘AAA’ paper also looks slightly wide to fair value against CMBS ‘AAA’, according to an earlier APS analysis. Finally, besides the tightened spreads in ‘A’ debt, its higher coupons than ‘AAA’ may have also contributed to its higher total returns this year.

Exhibit 3: CLO ‘AAA’ has traded cheap while ‘A’ has traded rich since March 2020

Sources: Amherst Pierpont Securities. Note: Secondary spreads reflect the par-weighted average of all CLOs that trade with reported cover bids. Fair value reflects the par-weighted average of all APS model estimates of fair value for all CLOs submitted through BWICs or other means. A description of the Amherst Pierpont CLO Fair Value Model is here. Source: Amherst Pierpont Securities

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