By the Numbers

Looking at CLO value after adjusting for average life

Caroline Chen | October 21, 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.

Investors in CLO debt often look for relative value in other floating-rate assets including single-asset-single-borrower (SASB) CMBS, CRE CLOs and ABS as well. And comparing these assets by rating is a natural relative value check. But these assets also differ significantly in weighted average life, which also should influence fair value. After factoring in differences in weighted average life, the top of the CLO capital stack looks like better relative value based on the new issue market.

Start with the new issue CLO credit curve

The average new broadly syndicated loan (BSL) CLO ‘AAA’ came to market in September around 207 bp over SOFR. The credit spread pickup from going ‘AAA’ to ‘AA’ averaged 93 bp. As investors go further down the capital stack, the spread pickup from each rating category increases to compensate for the additional credit risk to investors (Exhibit 1).

Exhibit 1: Spread pick up in BSL CLO new issue increases by rating categories

Note: data represents September BSL CLO new issuance market only.
Source: Bloomberg, Amherst Pierpont Securities

Every securitized asset in today’s new issue market offers more spread for taking more risk in lower-rated classes, but the steepness may differ. Take SASB CMBS as an example. Three new deals priced in September, and the average ‘AAA’ class spread was 227 bp, 20 bp wider than the average of ‘AAA’ BSL CLO. However, in SASB CMBS, the spread pickup going down the capital stack increases at a smaller magnitude (Exhibit 2).

Exhibit 2: Spread pickup in SASB CMBS new issue is less than BSL CLO

Note: data represents September BSL CLO new issuance market only.
Source: Bloomberg, Amherst Pierpont Securities

But duration or weighted average life needs to be considered as well

In addition to the credit risk implied by the bond ratings, investors holding bonds with a longer weighted average life need to be compensated for the incremental risk as well. The longer the weighted average life, the higher the probability of encountering significant change in fundamental or market conditions. Depending on the structure, the weighted average life of BSL CLO bonds may range from five years to nine years. By contrast, the SASB CMBS new issues are often priced to a 5-year full extension. A simple comparison of spread pickup levels at each rating category for different duration bonds does not factor in the duration risk investors would assume, a better comparison is to adjust the spread pick up by the square root of the weighted average life since options increase in value with the square root of time. After the adjustment, BSL CLO new issues in September remain attractive to SASB CMBS across the capital stack (Exhibit 3).

Exhibit 3: BSL CLO new issues remain appealing after factoring into the duration

Note: Spread pickup in each rating category is the average of new issue spread pickup divided by the square root of the assumed WAL. 7-year WAL is assumed for BSL CLO and 5-year WAL is assumed for SASB CBMS. Data reflects September new issue market.
Source: Bloomberg, Amherst Pierpont Securities

The ‘AA’ and ‘A’ CLOs offer better value while ‘BBB’ CLO spread pickup is average

Applying the same analysis to ABS, CRE CLOs and middle market CLOs priced in September, both ‘AA’ and ‘A’ new issue CLOs offer better compensation to investors for the additional credit and duration risk (Exhibit 4). The upper mezzanine tranche of middle market CLOs offered the highest spread compensation to investors in September.

By contrast, the spread pickup in the ‘BBB’ CLOs is in line with many ‘BBB’ bonds in other asset classes. While the absolute yield may be higher in ‘BBB’ CLO, CLO investors are not compensated more than investors in other asset classes after adjusting the WAL difference. For example, investors who prefer investment allocation to short-duration bonds may find ‘BBB’ subprime auto ABS more attractive. Since not all new deals will issue ‘BB’ rated classes, the values in ‘BB’ categories are based on limited observations.

Exhibit 4 ‘AA’ and ‘A’ CLOs offered better relative value in September

Notes: Spread pickup in each rating category are the average of new issue spread pickup divided by the square root of the assumed WAL. If a bond has split ratings, the lowest rating is used in the analysis. 3-year WAL is assumed for Subprime auto ABS and Subprime Auto Credit Linked Notes. 4-year WAL is assumed for unsecured consumer ABS and Equipment ABS. 5-year WAL is assumed for SASB CMBS and CRE CLO and 7-year WAL for CLOs. Data points reflect new issues in September only.
Source: Bloomberg, Amherst Pierpont Securities

Some worthwhile caveats

The analysis is based on the September new issue market data. Some asset classes will have limited data observation. For example, only one equipment ABS priced in September.
When calculating the spread pick up from each rating category, all rating agencies are included in the analysis. For example, four unsecured consumer ABS deals were priced in September including Affirm, Marlette, Bankers Healthcare Group, and LendingPoint. Except for the new deal issued by Bankers Healthcare Group, all remaining three ABS deals carry Kroll or Morningstar ratings only. By contrast, all new issue CLOs are rated by either Moody’s, S&P, or Fitch.

Analysis assumes credit risk at the same rating category are generally comparable across different asset classes. But the fundamental credit view may differ among investors. For example, investors who buy ‘BB’-rated SASB CMBS may view the credit risk lower in commercial real estate than leveraged loans or unsecured consumer loans despite the same rating.

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

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