CLOs: Finding Relative Value in the Age of Covid-19

Ample liquidity from central banks has helped fuel a notable recovery in various credit asset classes since the sharp market drop in March. Price recovery has been uneven, however, with structured products such as collateralized loan obligations (CLOs) experiencing a slower comeback. What might explain this trend, and what opportunities does this signal for investors? Read on to gain insights from Madelaine Jones, portfolio manager of Oaktree’s European Senior Loans strategy, and Brendan Beer, co-portfolio manager of our Structured Credit strategy.

Credit Markets’ Price Recovery since March

Q: Please describe the recovery trends in credit since the March nadir that was reached when markets sold off broadly amid Covid-19 fears. What can best explain the relatively slow recovery of CLOs?

Prices of investment grade credit, high yield bonds and senior loans have had a meaningful recovery so far. But prices of U.S. BB CLOs haven’t bounced back to anywhere near the same degree (see Figure 1). In Europe, too, while there’s been some tightening in yield spreads over the past month or so, we’re still well below the levels we saw at the start of the year. We find this to be noteworthy because today’s uncertain and challenging market environment affects all types of corporate fundamentals and credit securities.

As for the possible reasons for this trend, we turn first to policy actions. Many categories of corporate credit — namely investment grade debt, high yield bonds and senior loans — benefited early on in the pandemic from decisive and massive monetary and fiscal action, which helped create a powerful tailwind and restore demand from buyers. Structured credit did not get this sort of direct aid.

Also, investors are understandably concerned. They may have been traumatized by the price volatility; they may be dealing with downgrades and anticipating additional downgrades; and they may be concerned about a shift to payment-in-kind, or PIK-ing, of junior CLO tranches, which means the temporary interruption of coupon interest. There are also elevated expectations for corporate defaults, which require CLO managers to have distressed credit capabilities. But distressed credit experts have other things to attend to in the current recession. Structured credit hedge funds also may be busy dealing with redemptions and margin calls.

Putting aside the Covid-19 crisis for a moment, we also see more-general reasons for the slower recovery of CLOs. For one, CLOs are not included in widely accepted fixed income benchmarks; thus investors don’t have to own them to emulate the indices. Also, within asset management firms, CLOs often fall within the purview of either corporate credit teams or traditional structured products teams (i.e., those focused on mortgage-backed securities and asset-backed securities), or somewhere in between. This can result in a lack of clear ownership. Another hurdle for CLOs is the uncertainty around their average life assumptions, given that the asset class has a two-year non-call period and a five-to-eight-year expected life. This makes CLOs a relatively difficult product for asset/liability matchers. And, of course, there’s the association — an unfair one in our view — of CLOs with collateralized debt obligations and subprime MBS, which were the source of considerable losses for investors during the Global Financial Crisis.

Risks Considered in Today’s CLO Market

Q: But haven’t the sources of volatility abated somewhat? As in, today, don’t we have a good idea — at least better than we did in March and April — of what the headwinds are?

Right, we believe the risks are better understood today than they were early in the Covid-19 pandemic and at the start of the recession. For instance, with second-quarter earnings in the books, we have a better sense for which borrowers are affected by Covid-19 and to what degree, and hence a better idea of the potential for credit losses in the loans that underlie CLOs. Further, ratings agencies have been highly communicative and transparent for months, in direct response to investors’ growing interest in the effect of Covid-19 on companies and CLOs. This gives us a better view into which loans are being considered for downgrade and which tranches are being considered for downgrade.

In the European market, we can look to trends in primary issuance to see that there’s a better understanding of risks today than at the start of the crisis. Primary CLO issuance was either non-existent or very tentative between March and May, with truncated capital stack deals (i.e., few B or BB tranches), low leverage and cautious structures. More recently, however, we have seen the inclusion of the single-B category, as well as a marked tightening in yield spreads on AAA tranches, so obviously there is more confidence.

But overall, increased insight, as well as improvement in loan pricing and market sentiment, apparently hasn’t been enough to boost prices for CLOs as much as other credit asset categories.

Q: Markets continue to evolve, and there’s little doubt that we’ll face new or different disruptions. What challenges do you anticipate going forward?

Covid-19 has caused pronounced damage to economic activity and many corporate balance sheets. This disturbance, in turn, has caused and may further cause credit losses in the loan portfolios that underlie CLOs. To the extent these losses cannot be avoided or minimized through careful active management, they will be borne initially and primarily by CLO equity tranche investors. Trading prices of CLO equity tranches in secondary markets acknowledge this reality. However, we suspect that investors in the vehicles that own CLO equity may not yet understand that defaults will cause realized returns to fall short of previous expectations, and by non-trivial amounts. Are these investors and their managers too optimistic? Will investors direct their managers to sell CLO equity? Will they withdraw from other credit markets? These are all valid questions today. On balance, we view this delay in investor awareness as a distortion and a source of risk to the market. Taking these factors into consideration, we prefer new- or recent-issue deals backed by portfolios that were constructed subsequent to the onset of Covid-19.

The potential amount of future credit losses, as implied by loan trading prices or predicted by credit researchers, suggests a corresponding impact on CLO structures. Obviously, returns to each tranche of the CLO can’t be known in advance with certainty. They depend on multiple factors, including the individual CLO and the makeup of its underlying portfolio; the performance of the CLO manager; and the subjective interpretation by an investor in a particular tranche of all the relevant data and research. Having said that, we think the prices of “seasoned” junior CLO debt tranches (such as BB- rated) imply a much greater impact than can be reasonably inferred from loan prices or credit research. Either loan prices and credit researchers will be proven to have been too optimistic, or junior CLO debt tranche prices will be shown to have been too low. We think the latter is more likely.

New- or recent-issue CLOs have little exposure to stressed credits compared to seasoned CLOs. Still, when compared with the yields offered by performing high yield bonds, senior loans or investment grade-rated CLO tranches, BB tranches offer more yield than an investor would reasonably expect based on the historical relationship between such yields.

The Relative-Value Proposition for CLOs

Q: Given the current pricing trends and risk considerations for CLOs, what is the main takeaway for the investor?

We believe those factors, plus the lack of yield in traditional fixed income instruments, combine to highlight the attractive relative value offered by CLOs today. For instance, with the recent rally in high yield bonds, the yield differential between similarly rated CLO debt tranches and high yield bonds is fairly wide.

• As of the end of September, BB-rated U.S. CLO tranches offered a yield spread of 910 bps, versus 403 bps offered by BB-rated U.S. high yield bonds. This difference of 507 bps compares with the difference of 439 bps at the end of January (see Figure 2).

• Similarly, BB-rated European CLOs offered a yield spread of 740 bps at the end of September, versus 347 bps from BB-rated European high yield bonds. This difference of 393 bps compares with the difference of 306 bps in January.

• Even the BBB-rated tranches are showing non-negligible relative value: as of September 30, BBB-rated U.S. CLOs offered a yield spread of 458 bps, versus 178 bps from similarly rated corporate bonds. BBB-rated European CLOs offered a yield spread of 420 bps, versus 137 bps offered by their corporate-bond counterpart.

Of course, the relevance of these comparisons relies on comparability between the ratings on bonds and those on CLO tranches.

It’s worth recalling that we saw much wider spreads earlier this year — in March and April — and that the contraction of CLO spreads since then is working its way through the capital structure, tranche by tranche. If the trend continues, BB tranches should be next.

These unusually large yield differentials, as well as the continued recovery in high yield bond and senior loan markets, should drive investors to pay closer attention to CLOs. We feel CLOs are likely to remain relatively protected from losses even if defaults pick up and recovery rates decline. In the vast majority of CLOs, we expect credit losses to be absorbed entirely by the equity tranche investors. The debt tranches are protected by not only overcollateralization, but also by excess spread and additional overcollateralization expected to be built by future investment into discounted loans. If CLO debt tranches benefited from just today’s levels of overcollateralization, we would not be comfortable with the prospects for many junior CLO debt tranches. Given the clearer understanding of today’s market dynamics and headwinds, as mentioned before, we believe we are better able today to identify attractive opportunities in this environment than we were a few months ago.

ENDNOTES

¹ S&P Global Ratings.
² U.S. spreads data from ICE BofA indices and JPM CLO Post Crisis indices. European spreads data from Citigroup Global Markets and ICE Data Services.

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