A timely entry point in short ‘AAA’ CLOs

Caroline Chen | May 20, 2022

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.

The median credit spread for ‘AAA’ CLOs in the secondary market has widened from 130 bp at the beginning of the year to 200 bp recently. And the term curve in ‘AAA’ CLOs has become flat with short ‘AAA’ CLOs lately trading at mostly the same spreads as their long peers. Shorter ‘AAA’ CLOs typically offer more spread than long CLOs for each year of weighted average life, but the spread advantage has become particularly pronounced in recent weeks. It is a good entry point for investors managing short-duration fixed income portfolios.

The exact reason for the pronounced widening in short ‘AAA’ CLOs is hard to pin down. Spreads have moved wider throughout the year across the CLO term curve (Exhibit 1). Some of the widening may be in sympathy with competing investments. Some of it may reflect a significant rise in CLO bid list volume. And although fundamental credit performance is good, the bid list volume could reflect investors trying to get ahead of any credit issues created by higher rates and slower eventual growth.  Some investors may have decided to sell CLOs with the highest dollar price because price upside is limited and the investor need to raise cash, possibly in anticipation of future redemptions.

Exhibit 1. Spread compensation is roughly flat across CLO weighted average lives

Note: Only traded bonds with pricing talk color and cover bid price are used to derive the spread level.  20 CPR, 2CDR, 70% severity for cash flow run in INTEX.  The median spread levels for all traded positions are used in the chart.
Source: Kopen technologies, INTEX, Amherst Pierpont Securities

The flattening of the term curve in ‘AAA’ CLOs started in March with the median of 1- to 3-year WAL ‘AAA’ CLOs and 5-year and longer ‘AAA’ CLOs both at 161 bp.  The trend has continued in April and May.

Borrowing from the Sherman ratio concept in the corporate bond market, which divides bond yields over the duration to measure return to taking interest rate risk, calculating the credit spread for each unit of WAL is one way to gauge the spread sensitivity in different CLO buckets.  CLOs are floating-rate instruments that are largely shielded from the rising interest rate risk, but credit spread widening will cause the bond price to drop and ultimately erode investors’ returns earned from coupon.  For example, the median WAL for all traded ‘AAA’ bonds in the 1- to 3-year WAL bucket in May is 1.9 years and the median spread over 3-month SOFR for the same group is 197 bp.  The spread per unit of WAL for short ‘AAA’ CLOs, at 104 bp, is three times higher than the spread for CLOs having WAL over 5 years (Exhibit 2).  This leaves the long WAL ‘AAA’ CLOs more vulnerable to credit spread widening.

Exhibit 2. Short ‘AAA’ CLOs offers higher WAL adjusted spreads

Note: Only traded bonds with pricing talk color and cover bid price are used to derive the spread level.  20 CPR, 2CDR, 70% severity for cashflow run in INTEX.  The median spread levels and WAL for all traded positions are used in the chart.
Source: Kopen technologies, INTEX, Amherst Pierpont Securities

From a CLO structure perspective, the call risk differs for bonds in different WAL buckets. Unlike other fixed-income assets, CLO call risk is sensitive to credit spread movement instead of rate movement.   Most short ‘AAA’ CLOs are currently passed the non-call period and the reinvestment period or about to reach the end of the reinvestment period.  By contrast, the long WAL CLOs are in the non-call period and have years remaining until the end of the reinvestment period.  The callability of the shorter CLOs might explain some of the wider spread per unit WAL. However, a shorter reinvestment period should work in the opposite direction, tightening spreads. In a risk-off environment like today, any potential widening of credit spreads should make the call protection less valuable. Instead, investors should benefit more from allocating to seasoned vintages with low spread duration and low call protection.

The recent widening of ‘AAA’ CLOs spreads in secondary provides good opportunity for fixed income managers, especially those with short-duration mandates.  Not only are the ‘AAA’ CLOs spreads at wide levels compared to ‘AAA’ corporate debt, but the CLOs offered in secondary also trade wider than the primary market. The ‘AAA’ CLO index total return has outperformed the short-duration Bloomberg/Barclays US Corporate Index most of the time in the last decade when the 10-year US Treasury yield moved up by 80 bp or more (Exhibit 3).  As of May 18, the ‘AAA’ CLO index has outperformed the short-duration 1- to 3-year corporate index by 190 bp and the 1- to 5-year corporate index by 387 bp (Exhibit 3).

Exhibit 3.  ‘AAA’ CLO index total return outperformed in most rising rates environment

Note: current w.a. life of CLO ‘AAA’ tranches in the Palmer index is 3.8.  The Bloomberg US corporate 1-3 year index OAD is 1.87.  The Bloomberg US corporate 1-5 year index OAD is 2.71.
Source: Bloomberg, Amherst Pierpont Securities