By the Numbers
A duet is better than a solo
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Current wide spreads in CLOs may seem interesting but impractical for investors trying to buy longer corporate debt, but that is not entirely true. Pairing a CLO with Treasury debt can match the duration of a corporate bond and often provide more portfolio income and better projected return. And for insurers, the combination of a CLO and Treasury debt uses much less risk-based capital than a similarly rated corporate bond.
CLO + Treasury creates a position that matches the duration of corporate debt
OCT66 2022-1A Class A is a new par ‘AAA’ CLO with a coupon of 3-month term SOFR + 194 bp and a 3NC1 structure. The on-the -run 20-year Treasury note has a yield 3.31% and a duration of 13.94 years. By contrast, Johnson & Johnson has a ‘AAA’ bond outstanding trading at a yield of 3.37% with a duration of 4.16 years. An allocation of 30% to the on-the-run Treasury and 70% to the CLO bond creates a blended investment with a duration that matches the Johnson & Johnson bond (Exhibit 1).
Exhibit 1. A duration-neutral investment including ‘AAA’ CLO and Treasury
Source: Amherst Pierpont Securities, Bloomberg. Bond dollar price as of 7/5/2022
The blend investment outperforms corporate bond in all yield shift scenarios
The blend of CLO and Treasury produces higher projected returns than the corporate bond over moderate swings in rates. The total returns here come from interest payments, reinvestment of cash flows and bond price movement over one year under instant parallel rates shifts at settlement. Because a CLO is a floating-rate instrument, the rate shift impact on CLO price is assumed to be zero although the coupon changes. In addition, the interest received is reinvested at current bond yield. In all scenarios, the blend outperforms the corporate bond by between 13 bp to 115 bp (Exhibit 2).
Exhibit 2. The ‘AAA’ CLO + T delivers better performance
Source: Amherst Pierpont Securities, Bloomberg. Settlement date: 7/7/2022, Horizon Date: 6/29/2023, Bond dollar price as of 7/5/2022.
The strategy can be replicated with a longer, lower-rated corporate bond
The Class B1 from the same OCT66 deal is a ‘AA’ bond with a coupon of 3-month term SOFR + 260 bp and the same structure. Amazon has a ‘AA’ bond outstanding that trades at a yield of 3.83% with a duration of 7.4 years. A blend of 53% on-the-run 20-year Treasury notes and 47% of the ‘AA’ CLO matches the duration on the Amazon bond (Exhibit 3).
Exhibit 3. Another duration-neutral blend of ‘AA’ CLO and Treasury debt
Source: Amherst Pierpont Securities, Bloomberg. Bond dollar price as of 7/5/2022
In all scenarios, the blend outperforms the corporate bond (Exhibit 4).
Exhibit 4: The ‘AAA’ CLO + T delivers better performance
Source: Amherst Pierpont Securities, Bloomberg. Settlement date: 7/7/2022, Horizon Date: 6/29/2023, Bond dollar price as of 7/5/2022.
A CLO + Treasury blend saves risk-based capital
In addition to the better projected return profile, the proposed blended investment will allow insurers to use their capital more efficiently. Treasury debt requires no risk-based capital. In above two examples, an insurer consequently will save nearly 30% of the capital charge in the ‘AAA’ case and 53% in the ‘AA’ case compared to corporate bonds with the same rating.
Caveats
Blending a CLO with a longer Treasury note does involve duration drift and reinvestment risk once the CLO begins to amortize. The investor may not be able to replace the initial CLO with one offering sufficient spread. The CLO spread will need to be at least [1/(CLO allocation)]. In the ‘AAA’ example, that becomes [1/0.7016] or 1.42x. In the ‘AA’ example, that becomes [1/0.47] or 2.13x.
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