‘AA’ classes look rich and likely to get richer
admin | December 11, 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 have largely recovered from the Covid shocks of March with one class of CLO debt doing especially well. CLO ‘AA’ classes have tightened well inside pre-Covid levels compared to similarly rated corporate debt while other CLO classes look roughly like fair value. The likely explanation has everything to do with cash flow protection in ‘AA’ debt that approaches the protection of ‘AAA’ while offering much more yield. ’AA’ CLOs could get richer.
CLO debt has rebounded from wide levels in March
CLO debt historically has traded at a wider spread than comparable corporate debt. In mid-February, for example, the Palmer Square CLO indices showed a spread to the ICE BoA US Corporate indices of 58 bp in ‘AAA’, 110 bp in ‘AA’, 141 bp in ‘A’, 193 bp in ‘BBB’ and 454 bp in ‘BB’ (Exhibit 1). Among other things, the spread should represent concession for any differences in liquidity between structured and corporate credit and for differences in recovery after default. Equal rating may arguably represent equal probability of taking the first $1 of loss in either a structured or corporate bond, but recovery of invested principal could be very different and likely less in a structured security. That is consistent with a wider spread in a structured security for the same rating.
Exhibit 1: The CLO-to-corporate spread has largely rebounded, especially in ‘AA’
Source: Palmer Square, ICE BoA US Corporate Indexes via the Federal Reserve Bank of St Louis, Amherst Pierpont Securities
The potential appeal of ‘AA’
Across rating categories, ‘AA’ CLOs stand out as rich to corporate ‘AA’ on two measures. First, the current ‘AA’ CLO-to-corporate spread of less than 100 bp is well inside the February 20 spread of 110 bp. The current spread in all other rating classes is either basically flat to February 20 levels or wide. This measure does not account for differences in volatility across these spreads, however, and the pattern could be a bit random. Converting current spreads into Z-scores using the average difference over the last year and the standard deviation, the ‘AA’ CLOs again look rich, standing 1.1 standard deviations tight to the average while all other classes stand only 0.7 standard deviations tight. Both measures suggest ‘AA’ CLOs look rich to corporates.
The rich get richer
CLO ‘AA’ classes likely have drawn a strong bid for their combination of cash flow protection and yield. CLO ‘AA’s are nearly as well protected as CLO ‘AAA’s, as interest payments to both classes have priority if an overcollateralization test fails and cash flow gets diverted from more junior classes. That obviously was the case before Covid, but since Covid and the consequent tripping of overcollateralization tests in many CLOs, the value of the protection has become more concrete. At the same time, CLO ‘AA’s offer more yield than CLO ‘AAA’s. The Palmer Square indices show roughly 50 bp more yield for ‘AA’. In a market starved for income, the combination apparently has become especially valuable.
It is highly likely that ‘AA’ CLOs will remain rich to ‘AA’ corporate debt and get even richer. Low rates and Fed QE should continue forcing a wide range of portfolios to take risk. The ability to get nearly a 2% floating-rate coupon with a ‘AA’ rating and good cash flow protection should prove attractive. The outperformance of ‘AA’ looks far from over.
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