Uncategorized

‘AA’ classes look rich and likely to get richer

| 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.

admin
jkillian@apsec.com
john.killian@santander.us 1 (646) 776-7714

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.

Important Disclaimers

Copyright © 2024 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.

The Library

Search Articles