By the Numbers
Quality CLO portfolios top the market and peers again
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.
Quality loan portfolios continued to rack up good returns for CLO managers for the three months ending in July. Returns on quality books beat the broad leveraged loan market by an average of 8 bp after adjusting for risk while speculative books trailed by 19 bp. That left the average CLO portfolio behind the broad leveraged loan market by 12 bp. The latest win adds to a long record of quality portfolios beating both the broad market and their peers.
Of the $732 billion in CLO AUM tracked by Santander US Capital Markets, 26% falls under managers that tend to generate month-to-month returns less volatile than the Morningstar/LSTA Leveraged Loan Index (Exhibit 1). These quality managers show an average beta—or sensitivity to the index—of 0.96, implying 4% less risk than the market overall. From May through July, the index returned 1.98%. Based on the average beta, quality portfolios should have delivered 1.91%. They delivered 1.99% instead, outperforming by 8 bp.
Exhibit 1: Quality tops the loan market by 8 bp, speculative trails by 19 bp
Note: Performance for managers with five or more deals issued since January 1, 2011, and tracked by Santander US Capital Markets. Performance attribution starts with calculated total return on the leveraged loan portfolio held in each CLO for the 3-month reporting period ending on the indicated date. CLOs, even with a single manager platform, may vary in reporting period. The analysis matches performance in each period to performance over the identical period in the Morningstar/LSTA Leveraged Loan Index. Where a deal has at least 18 months of performance history since pricing and no apparent errors in cash flow data, the analysis calculates a deal beta. The deal beta is multiplied by the index return to predict deal return attributable to broad market performance. Where no beta can be calculated, the analysis uses the average beta across manager deals weighted by the average deal principal balance over time. Any difference between performance attributes to beta and actual performance is attributed to manager alpha.
Source: INTEX, Markit, Santander US Capital Markets LLC
The balance of the CLO AUM tracked by Santander US Capital Markets falls under managers that tend to generate more volatile month-to-month returns. These speculative managers show an average beta of 1.04, implying 4% more risk than the overall market. Over a period that differed slightly from quality managers due to different deal reporting dates, the index returned 1.96%. Based on beta, the speculative portfolios should have delivered 2.05%. Instead, they delivered 1.86%, underperforming by 19 bp.
Despite the average results across quality and speculative books, some quality books did trail the index through July and some speculative books beat the index. Among quality managers, 58% beat the index through July after adjusting for risk while 42% trailed (Exhibit 2). And among speculative managers, 40% beat the index while 60% trailed.
Exhibit 2: The distribution of excess return across quality, speculative managers
Note: Percentage based on manager count not AUM.
Source: INTEX, Markit, Santander US Capital Markets LLC.
If portfolio beta captures the relative volatility of returns, it should be correlated with other measures of loan portfolio risk. And that is the case. Using managers’ aggregate portfolio attributes as of the start of May, higher spread, higher ‘CCC’ exposure and higher exposure to defaulted loans all correlated modestly with higher beta (Exhibit 3). On the other hand, higher weighted average loan price correlated with lower beta.
Exhibit 3: High risk loan attributes raise beta, higher prices lower beta
Note: Correlation between loan or deal attributes at the start of May 2024 and manager beta as calculated by Santander US Capital Markets.
Source: INTEX, Markit, Santander US Capital Markets LLC.
At least two broad possibilities could explain the tendency for excess return to fall as beta increases:
- Risky loans trade rich, safer loans trade cheap. This would happen if managers competing to deliver returns to CLO equity crowd into riskier loans with wider spreads that drive up portfolio beta and drive down the potential for excess return. Crowding into risk arguably leaves safer loans with lower beta trading at much better valuations. A wide range of research often tagged as betting against beta finds this pattern in US equities, 20 international equity markets, Treasury and corporate bonds and futures. If betting against beta is driving CLO loan portfolio beta and alpha, then equity and debt investors are getting a genuinely better investment performance.
- Illiquid loans show low beta, high alpha. Illiquid loans with stale prices show low beta to market indices and high alpha, at least when loan returns are positive. There’s no magic to this. It’s purely from the low correlation between any asset with stale pricing and any more liquid mark-to-market index. If illiquidity is driving CLO loan portfolio beta and alpha, then the better investment performance is more optics than reality.
Both explanations likely contribute to this consistent result in CLO loan portfolios, but betting against beta is likely the bigger effect. Low beta portfolios should deliver better ultimate loan returns or more stable returns or both. Those higher-quality returns should accrue to the benefit of CLO equity and debt.
The rankings are in
For the three months ending in July, Anchorage, Nuveen, American Money, CVC and Allstate make up the Top 5 in excess return with Napier Park, AXA, Neuberger, Aegon and Credit Suisse rounding out the Top 10 (Exhibit 4).
Exhibit 4: CLO managers ranked by excess loan portfolio return through July
Note: Performance for managers with five or more deals issued since January 1, 2011, and tracked by SanCap. Performance attribution starts with calculated total return on the leveraged loan portfolio held in each CLO for the 3-month reporting period ending on the indicated date. CLOs, even with a single manager platform, may vary in reporting period. The analysis matches performance in each period to performance over the identical period in the Morningstar/LSTA Leveraged Loan Index. Where a deal has at least 18 months of performance history since pricing and no apparent errors in cash flow data, the analysis calculates a deal beta. The deal beta is multiplied by the index return to predict deal return attributable to broad market performance. Where no beta can be calculated, the analysis uses the average beta across manager deals weighted by the average deal principal balance over time. Any difference between performance attributes to beta and actual performance is attributed to manager alpha.
Source: INTEX, Markit, Santander US Capital Markets LLC
A link to Santander US Capital Market’s latest CLO manager bubble chart and to data on more than 138 managers and more than 2,200 active and expired deals is here.
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