By the Numbers

Quality wins again, but speculative CLO books close the gap

Steven Abrahams | November 15, 2024

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.

The average CLO loan portfolio notched another month of strong performance through October with returns well above the broad leveraged loan market. The average book for the three months ending in October added 17 bp in excess return after adjusting for risk. Quality portfolios still beat the broad market with an average 20 bp of excess return and beat speculative portfolios, which delivered an average 15 bp of excess return. But the 5 bp alpha gap between quality and speculative books marked a steady narrowing of performance across styles since late summer.

Strong recent performance overall

The $764 billion in CLO AUM currently in the hands of managers with five or more active deals delivered a 2.39% return for the three reporting periods ending in October (Exhibit 1). The Morningstar/LSTA Leveraged Loan Index over the same period delivered 2.18%. However, the average CLO portfolio shows a beta of 1.02, indicating 2% more risk or volatility than the index. A passive portfolio with that beta should have delivered a 2.22% return. The difference between realized and beta-adjusted return leaves the average portfolio with 17 bp of excess return.

Exhibit 1: Strong excess returns with quality topping the market and peers

Note: Performance for the three monthly reporting dates before October 20, 2024, 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

Quality books outperform the index and peers

Of the AUM tracked, $209 billion or 27% falls under managers that tend to generate month-to-month returns less volatile than the Morningstar/LSTA Leveraged Loan Index. These quality managers show an average beta of 0.96, implying 4% less risk than the market overall. From July through September, based on the different reporting dates of managers, the index returned 2.19%. Based on the average beta weighted by CLO AUM, quality portfolios should have delivered 2.11%. They delivered 2.30% instead, outperforming by a rounded 20 bp.

The remaining $555 billion balance of the CLO AUM tracked by Santander US Capital Markets, or 73% of the total, 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 2.18%. Based on beta, the speculative portfolios should have delivered 2.27%. Instead, they delivered 2.42%, outperforming by 15 bp.

Although quality managers again delivered lower absolute returns but more alpha than speculative managers, the alpha gap between the styles narrowed to 5 bp. In the three reporting periods ending in September, quality alpha exceeded speculative by 8 bp. For the periods ending in August, quality alpha topped speculative by 12 bp.

More than just management style

Across the 80 managers tracked, a drop in beta of 0.1 or, equivalently a drop of 1% in portfolio risk, raised excess return through August by an average 1.1 bp (Exhibit 2). But beta or manager style explained only 5% of total differences in excess returns across managers, one of the lowest levels in months, leaving the rest possibly explained by style drift in recent months, other features of the manager or simply error in measuring recent manager beta. The low share of performance explained by style is consistent with the narrowing alpha gap between the categories.

Exhibit 2: A drop in beta of 0.01 lifted excess return by 1.1 bp

Note: See notes to earlier exhibits.
Source: INTEX, Markit, Santander US Capital Markets LLC

Possible explanations for the impact of style

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 for October are in

For the three months ending in September, ICG, Bardin Hill, Brigade, LCM and PineBridge make up the Top 5 in excess return with Aegon, Octagon, Vibrant, Crescent and First Eagle rounding out the Top 10 (Exhibit 3).

Exhibit 3: CLO managers ranked by excess loan portfolio return through August

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.

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

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