By the Numbers

A duet is better than a solo

| July 8, 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.

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.

Caroline Chen
caroline.chen@santander.us
1 (646) 776-7809

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