By the Numbers
Measuring market expectations of CLO manager credit expertise
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 every new CLO have to make some judgement of how the risks in the deal will play out and then reflect it in spreads. When it comes to the manager’s influence, spreads across different CLO classes carry valuable information. Every class likely reflects managers’ influence on liquidity, but spreads in the most junior class likely reflect particular expectations of credit expertise. That creates an important market signal of managers’ expected ability to navigate years of credit risk ahead. Not surprisingly, the market implies that managers are far from equal. And even investors in ‘AAA’ CLO debt should care about that.
Assume liquidity gets priced equally across every class of a manager’s debt
Let’s start with a simple assumption: all debt issued by a manager’s platform reflects expected future liquidity. If a manager has issued lots of CLOs and has a broad investor base that trades regularly, then new issue spreads will come tighter than average. If the manager has barely issued and has a narrow base that trades infrequently, then new issue spreads will come wider than average. The tendency for expected liquidity to affect spreads should apply to all classes from ‘AAA’ down to ‘BB’.
Little credit risk is priced in ‘AAA’, lots in ‘BB’
If spreads across classes of a manager’s debt reflect equal expectations of liquidity, then spreads in the most senior and most junior classes say very different things about expected credit expertise. The ‘AAA’ class has low credit exposure, the ‘BB’ has high exposure. Where those different classes price relative to peers sends a signal about relative credit expertise.
Imagine, for example, a manager whose new 5-year non-call 2-year ‘AAA’ debt gets issued at roughly the average market spread while it’s ‘BB’ debt gets issued at the tight end of the market range. If the loan portfolios and structures in the market at the time have roughly equal static credit risk, then market pricing arguably implies a better-than-average manager. On the other hand, a manager that issues ‘AAA’ at the market average while it’s ‘BB’ debt trades wide arguably looks to the market like a weaker-than-average manager.
Measuring relative ‘AAA’ and ‘BB’ spreads
Santander US Capital Markets for years has measured managers’ relative new issue CLO debt spreads. The approach is relatively straightforward. To slightly simplify:
- Identify all new 5NC2 CLOs in the market within a 30-day window, limiting the window to roughly keep market conditions in a narrow range
- For each deal, capture the issued margin over the floating index for every rating class
- For each rating class within a deal, compare that margin to all margins in the market at that rating level and calculate a Z-score; for example, if a new ‘AAA’ class comes at SOFR + 120 bp in a market where the average ‘AAA’ is SOFR + 125 bp with a standard deviation of 5 bp, then Z = (120 – 125)/5 = -1.0
The result is a Z-score for every class of debt issued by every manager since 2010, creating the raw material for comparing relative pricing on ‘AAA’ to relative pricing on ‘BB’.
Deals can obviously come to market with a price below par where the actual discount margin is much higher than the nominal one. Santander has compared Z-scores across hundreds of deals using both the nominal margin and published discount margin. The results are very highly correlated, implying that the possibility of issuing debt below par does not materially change conclusions.
Focusing on the Top 20
To see if the market distinguishes managers by expected credit expertise, I took 20 managers with significant CLO issuance since 2010 and pulled up every deal done since the start of 2022 (Exhibit 1). The number of deals done ranged from four to 20. For each deal, I pulled the Z-score for each class of debt. And then I took the average ‘AAA’ Z-score and the average ‘BB’ Z-score.
Exhibit 1: Top 20 CLO managers by post-2010 issuance
Source: INTEX, Santander US Capital Markets
Plotting relative ‘AAA’ spreads against ‘BB’
Plotting the calculated average ‘AAA’ Z-score against the average ‘BB’ Z-score shows that not all managers are equal (Exhibit 2). If every manager had the same Z-score for ‘AAA’ and ‘BB’, all the plotted points would fall along a 45-degree line. Instead, many fall above the line, implying the market sees their credit management as less impressive than their expected liquidity. A few managers fall below the line, implying the market see their credit expertise as more impressive than their expected liquidity.
Exhibit 2: Some weaker, some stronger on expected credit
Source: INTEX, Santander US Capital Markets
Using the market’s signal
All else equal, investors obviously should own debt issued by managers with better expected credit results. Those managers are more likely to pick loans well suited to their expertise and style, trade them more effectively, see less credit deterioration, avoid breaching quality, interest coverage or overcollateralization tests and mitigate any failed tests faster. Investors can use historical credit performance as a guide, but the new issue market expresses an opinion as well. That visible opinion lets investors in ‘AAA’ debt crowdsource the expertise of ‘BB’ investors and presumably end up with better investments along the way.
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.
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