By the Numbers

Better relative value on average in CLO primary offers

Caroline Chen | May 5, 2023

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.

The CLO market generally does a good job of moving spreads around to reflect relative credit, but this year the primary market is offering some debt at spreads wide to the outstanding universe of similarly rated CLOs but with better credit than the outstanding universe. That makes the average new issue offering look like good relative value. The better value is particularly notable in new ‘AA’, ‘A’ and ‘BBB’ classes.

Linking CLO secondary and primary market spreads through MVOC

CLO debt spreads should obviously depend on credit risk, and a key measure of that risk in a CLO is MVOC—the market value of CLO loan collateral as a percent of the par value of a CLO debt class and all classes senior to it. If the par value of a ‘BB’ class and all senior classes made up 90% of the market value of the collateral, for example, the MVOC would be 100/90 or 111. The higher the MVOC, the tighter the debt spread. The lower the MVOC, the wider. Other factors may influence credit spreads, including supply and demand, broad market volatility, and bond duration but credit risk is always an important component.

The average spread and MVOC on secondary trades are hard to determine, mainly because a substantial portion of secondary trading prices and trade status goes unreported. But the Palmer Square indices can serve as a proxy for spread, and the average MVOC of the outstanding CLO universe can serve as a proxy for the secondary market. Of course, this implicitly assumes that aggregate secondary trading flows are representative of the outstanding CLO universe. That may or may not be strictly true, but it is a convenient starting place.

The MVOC gap between secondary and primary markets looks at the average MVOC difference between the outstanding CLO universe and the new issues in that year. A positive MVOC gap indicates the outstanding secondary universe debt has stronger credit than the new issue universe. A negative gap indicates the opposite. The spread gap between secondary and primary markets, on the other hand, is the difference between the average spread of the Palmer index over a year and the average pricing discount margin for new issues in the same year. A positive MVOC gap should come with a negative spread gap – stronger credit should come with tighter spreads.

In fact, that is the observed pattern (Exhibit 1). For example, the universe of outstanding ‘AAA’ debt had an MVOC 7.3 percentage points higher than new issue ‘AAA’ at the end of 2021. Secondary ‘AAA’ also traded tight to primary. By contrast, this year outstanding ‘BB’ debt has an MVOC 7.4 percentage points below primary, and secondary ‘BB’ trades about 170 bp wider.

Exhibit 1: Compare MVOC and spreads between secondary and primary markets

Notes: i) New issue average spreads are derived from the pricing discount margin for all BSL CLOs with a reinvestment period of more than 4.5 years. CLO debt with no pricing DM reported is excluded from analysis; ii)Palmer Square CLO SOFR indices are used as proxies for secondary market spreads in 2022 and 2023. Palmer Square CLO Libor indices are used as proxies for secondary market spreads in 2020 and 2021. iii)MVOC of secondary markets is the weighted average MVOC of bthe outstanding BSL CLO universe at year-end as a proxy. Weights are based on the aggregate collateral balance by vintage. Older vintage CLOs that are in the post-reinvestment period with bonds and collateral amortizing may have very high MVOC but have smaller weights in average MVOC calculations. iv)Palmer index data are as of Apr 27, 2023. New issue spread data in 2023 as of Apr 21, 2023.
Source: LCD, Intex, Bloomberg, Santander US Capital Markets LLC

‘BBB’ new issue CLOs look like better relative value than secondary

This year, the average pricing spread for the new issue ‘BBB’ with a 5-year reinvestment period is around 545 bp over SOFR. The secondary spread, as implied by the Palmer index, averaged 510 bp in the first four months of the year. However, the MVOC of the new issue ‘BBB’ is about 6 percentage points higher than the ‘BBB’ universe (Exhibit 2). In other words, new ‘BBB’ debt has priced generally wider than the universe despite a stronger MVOC. Investors who like to deploy capital into mezzanine debt may find new issue ‘BBB’ spreads more appealing than many secondary trades.

Exhibit 2: New issue ‘BBB’ this year are at higher MVOC but wider pricing DM

Note: i)New issue average spreads reflects new issue ‘BBB’ pricing DM from Jan to Apr 21, 2023. Only new issue with more than 4.5 year reinvestment periods are included in analysis. ii)Palmer ‘BBB’ SOFR index are used as proxy for secondary spreads. Iii)MVOC are based on INTEX reports as of Apr 2023. MVOC of outstanding ‘BBB’ universe are weighted by vintage collateral balance.
Source: LCD, INTEX, Bloomberg, Santander US Capital Markets LLC

New issue ‘AA’ spread is close to the secondary despite higher MVOC

In addition to ‘BBB’, ‘AA’ is another rating class where spreads seem out of synch with MVOC. The average MVOC of new issue ‘AA’ this year is around 131.67%, about 3.9 percentage points higher than the average MVOC of the outstanding ‘AA’ CLO universe. However, the new issue ‘AA’ priced at an average of 255 bp over SOFR, 3 bp wider than the average of the Palmer index (Exhibit 3). In 2020, when ‘AA’ new issue had an average 2.4 percentage points higher MVOC than the outstanding of ‘AA’ universe, they were priced at an average of 28 bp tighter than the secondary trades. Investors may find the new issue ‘AA’ attractive at the current spread level.

Exhibit 3: New issue ‘AA’ also offers good relative value

Note: i)New issue average spreads reflects new issue ‘AA’ pricing DM from Jan to Apr 21, 2023. Only new issue with more than 4.5 year reinvestment periods are included in analysis. ii)Palmer ‘BBB’ SOFR index are used as proxy for secondary spreads. Iii)MVOC are based on INTEX reports as of Apr 2023. MVOC of outstanding ‘AA’ universe are weighted by vintage collateral balance.
Source: LCD, INTEX, Bloomberg, Santander US Capital Markets LLC

‘A’ secondary spreads may be vulnerable to credit performance

The secondary and primary market MVOC and spread gap of ‘A’ this year get a little closer to the right relationship between spread and MVOC. The average MVOC of the outstanding ‘A’ CLO universe at 117.2% is about 5 percentage points lower than that of the new issue, and the secondary ‘A’ spreads stand 13 bp wider from ‘A’ new issue (Exhibit 4). However, when the secondary ‘A’ MVOC was about 3 percentage points lower than that of the primary market new issue in 2020, secondary ‘A’ traded 36 bp wider than new issue, three times today’s level (Exhibit 3). Investors may want to flag weak ‘A’ with the current lower-than-average MVOC. At the current spread level, as Palmer index indicates, those ‘A’ may look less appealing in the secondary. Secondary ‘A’ debt may have room to widen further.

Exhibit 4: Secondary ‘A’ may gap wider if performance deteriorates

Notes: i) New issue average spreads are derived from the pricing discount margin for all BSL CLOs with a reinvestment period of more than 4.5 years. CLO debt with no pricing DM reported is excluded from analysis; ii)Palmer Square CLO SOFR indices are used as proxies for secondary market spreads in 2022 and 2023. Palmer Square CLO Libor indices are used as proxies for secondary market spreads in 2020 and 2021. iii)MVOC of secondary markets is the weighted average MVOC of the outstanding BSL CLO universe at year-end as a proxy. Weights are based on the aggregate collateral balance by vintage. Older vintage CLOs that are in the post-reinvestment period with bonds and collateral amortizing may have very high MVOC but have smaller weights in average MVOC calculations. iv)Palmer index data are as of Apr 27, 2023. New issue spread data in 2023 as of Apr 21, 2023.
Source: LCD, INTEX, Bloomberg, Santander US Capital Markets LLC

These spread and MVOC levels obvious represent broad averages, and individual new issue and secondary offers could differ from these averages substantially. The averages nevertheless point to the part of the market where better value is more likely to show up.

Bond spread movements are often influenced by more than one factor. In CLO, managers’ merger and acquisition activity, new issue and BWIC supply, bond duration, as well as broad market volatility, may all contribute to the spread movement in addition to the credit risk. Nevertheless, focusing on credit performance differences is always important. And in ‘AA’, ‘A’ and ‘BBB’, after considering MVOC, primary new issues are much more attractive than the secondary.

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

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