The Big Idea

Efficiently leveraging CLO returns

| July 29, 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.

Some leveraged portfolios have started taking a new look at CLOs, with spreads and funding on ‘AAA’ through ‘BB’ debt showing potential fully leveraged returns starting in the mid-teens. But those returns need to get adjusted for differences in market risk across ratings. After adjusting, leveraged positions in the safest CLO debt look like the most efficient source of returns.

Fully leveraged cash flow ROE starting in the mid-teens

Current spreads and funding would seem to point to CLO debt with the lowest ratings as the best source of returns. CLO debt issued earlier this year with 5-year reinvestment and 2-year non-call periods, for example, trade in the secondary market at spreads to 3-month SOFR ranging from 180 bp for a typical ‘AAA’ to as wide as 800 bp for ‘BB’ (Exhibit 1).  Investors can fund these positions at different repo rates and haircuts. Funding for ‘AAA’ debt, for example, comes at 3-month SOFR + 70 bp with a haircut or equity investment of 10%. Funding for ‘BB’ debt comes at 3-month SOFR + 130 bp with a haircut of 30%. The spreads and funding on CLO debt create potential return on equity ranging from near 14% for ‘AAA’ to nearly 25% for ‘BB’. If these were the only considerations, ‘BB’ debt wins.

Exhibit 1: Current CLO spreads, funding point to ROE in the mid-teens and up

Note: Indicative levels only as of 27 Jul 2022. ROE calculations assume mid-market cost of funds, mid-market haircuts and a riskless rate of 2.57%. CLO debt spreads may vary across deal and manager. Repo terms may vary based on the credit risk of the repo counterparty. Total leveraged return could vary significantly from these levels due to changes in asset price.
Source: Amherst Pierpont Securities

Differences in volatility and drawdowns

The biggest risk in any leveraged position is the potential for margin calls, and that depends on the volatility of daily returns. The greater the volatility of returns, the greater the risk of a significant drawdown requiring the investor to add substantial margin. Margin calls can put portfolios out of business.

From the start of 2017 through July this year, daily volatility of CLO returns predictably rose as rating on the debt declined (Exhibit 2). Daily returns on ‘AAA’ debt, for example, had an annualized volatility of 1.7% while ‘BB’ debt had an annualized volatility of 8.8%—5.15 times the volatility of ‘AAA’.

Exhibit 2: CLO debt shows sizable differences across rating in return, volatility

Note: annualized daily returns and standard deviation of returns based on the Palmer Square CLO indices and on the S&P/LSTA Leveraged Loan Total Return Index from 12/31/2016 to 7/25/2022.
Source: Bloomberg, Amherst Pierpont Securities.

Some leveraged investors and their collateralized lenders like to look at return volatility in terms of the largest 1-day loss to get a sense of the largest potential margin call if history repeats itself. Since the beginning of 2017, the magnitude of the largest 1-day loss also tracks risk (Exhibit 3). ‘AAA’ debt showed a largest 1-day loss since early 2017 of 1.2%, for example, while ‘BB’ debt showed a largest 1-day loss of 12.7%—10.85 times the loss of ‘AAA’.

Exhibit 3: CLO debt shows sizable differences across rating in 1-day loss

Note: based on daily returns in the Palmer Square CLO index at each rating level and from 12/31/2016 to 7/25/2022.
Source: Bloomberg, Amherst Pierpont Securities.

Adjusting repo haircuts for asset volatility

The relative volatility of CLO debt returns is not consistently reflected in current haircuts. Volatility and haircut should track each other. But as rating goes from ‘AAA’ to ‘BB’, volatility as a multiple of ‘AAA’ largely rises faster than haircut as a multiple of ‘AAA’ (Exhibit 4). The volatility of ‘BB’ debt is 5.15 times the volatility of ‘AAA’, as noted, but the haircut is only 3.00 times the haircut on ‘AAA’. Relative volatility of returns argues that haircuts on CLOs below ‘AAA’—except for ‘A’ classes—should be higher.

Exhibit 4: Return volatility rises across rating faster than haircut

Source: Amherst Pierpont Securities

Adjusting haircuts to reflect relative risk—or adjusting haircuts so an investor has equal chance of a margin call across ratings—changes potential return on equity. The higher haircuts on ‘AA’ and lower-rated debt drive potential return on equity toward or below levels on ‘AAA’. Return on ‘BB’ debt drops to 15.6%, only marginally above ‘AAA’. Return on other classes falls below ‘AAA’.

Exhibit 5: Adjusting haircuts to reflect return volatility lowers ROE below ‘AAA’

Note: Indicative levels only as of 27 Jul 2022. ROE calculations assume mid-market cost of funds, mid-market haircuts and a riskless rate of 2.57%. Haircuts are adjusted to mirror the relative volatility of each rating class. CLO debt spreads may vary across deal and manager. Repo terms may vary based on the credit risk of the repo counterparty.
Source: Amherst Pierpont Securities

Differences in maximum drawdowns across CLO ratings are much bigger than differences in return volatility. Repo lenders do not set haircuts based on drawdowns, relying first on the financial strength of the counterparty, but ‘AAA’ CLOs could withstand more consecutive drawdowns than ‘BB’ CLOs before exhausting posted margin. With posted margin of 10%, a ‘AAA’ class could withstand more than eight consecutive days of 1.2% drawdowns; a ‘BB’ class with a 30% haircut would exhaust posted margin in less than three days of 12.7% drawdowns.

Leverage the top of the CLO cap stack

Investors drawn by recent wide spreads into leveraged positions in CLOs might be tempted by potential cash flow returns in classes with the widest spreads. But investors protecting capital and solvency from potential margin calls look better off taking positions in ‘AAA’. If past is prologue, investing in the strongest part of the capital stack should deliver the most efficient returns.

Steven Abrahams
steven.abrahams@santander.us
1 (646) 776-7864

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