Deja vu for CLOs?

Strong economic growth and an improving fundamental backdrop led to further positive performance across the collateralized loan obligation (CLO) market in the second quarter. Overall, AAA, AA and single-A tranches returned 0.31%, 0.41% and 0.66%, respectively. BBB, BB and single-B tranches also delivered positive returns, at 1.44%, 4.44% and 6.20%.¹
 

Late-Quarter Supply Surge

In many ways, activity in the second quarter mirrored that of the first. Indeed, as supply moderated early in the quarter after a surge in March, spreads tightened considerably, in some cases approaching the tights from early this year. However, as the market geared up for its second quarterly payment date, June brought with it a wave of refinancings and resets as CLO equity holders looked to capitalize on tighter spreads and a lower cost of capital. Accordingly, issuance surged in the second quarter, with $110.2 billion pricing in the U.S. and €26.2 billion in Europe—a large portion of which came from refinancing or reset transactions.²

As the heavy supply tested the market, spreads began to widen across the capital structure, particularly in lower-rated BB tranches. Of note, and despite the spread widening, the underlying risk profile for CLOs continues to improve, and the asset class remains on solid footing from a fundamental perspective. In fact, downgrades to underlying loans have virtually stopped after being much less severe than some market participants were calling for at the height of the crisis. Default expectations and credit metrics also continue to improve. In our view, this suggests that the recent spread widening is largely a result of a technical in the market—the heavy supply—rather than any material deterioration in fundamentals.
 

FIGURE 1: HEAVY SUPPLY RESULTING IN PERIODS OF SPREAD WIDENING

Source: J.P. Morgan. As of June 30, 2021.

Overlooked Opportunities & Relative Value

Against this backdrop, reset deals look particularly attractive. Although these deals typically have greater exposure to COVID-impacted sectors, they are often high quality and, in many cases, have taken little or no losses. However, they are sometimes being overlooked by the market given the volume of new issue, refinancing and reset activity, which has created challenges for investors, dealers and ratings agencies. Compounding this, CLO documentation in the market has grown increasingly complicated in recent years, meaning significant, dedicated resources are required to appropriately underwrite deals. As a result of these factors, some investors have gravitated more toward pure new issues from managers they know and trust, rather than spending the extra time and resources digging into deals issue-by-issue. 

For active managers with deep resources and an experienced team, these challenges can also lead to attractive relative value opportunities. Looking at the mezzanine part of the capital structure, for instance, reset BB deals have been trading 35-75 basis points (bps) wider than pure new issues—a significant difference in pricing that, in our view, is not justified by the difference in underlying credit quality. It’s a similar story higher up in the capital structure, where BBBs are trading roughly 15-35 bps wider than new issues.³  These spread levels also represent a meaningful pick-up over similarly rated investment grade and high yield corporate credit, underscoring the potential benefit of including the asset class as part of a broader multi-strategy mandate.
 

What’s Next?

Interest rates and inflation are top of mind for many investors, and it is worth reiterating that relative to fixed rate asset classes like high yield or investment grade corporate bonds, prices on CLOs have historically been stable in rising rate environments. This is partly because CLOs offer floating-rate coupons, which lower duration, or interest rate risk, over time. 

Looking ahead to the second half of the year, strong economic growth will likely keep demand strong. Supply should also remain robust as 2020 vintage deals continue to roll off their non-call periods. Barring any unforeseen shocks, we expect this dynamic to result in somewhat predictable periods of spread widening going forward, as refinancing and reset activity escalates in advance of quarterly payment dates. However, active management coupled with deep resources, will be critical to identifying the resulting relative value opportunities and will undoubtedly be a key differentiator in performance.
 

1. Source: J.P. Morgan CLOIE Index. As of June 30, 2021. 
2. Source: J.P. Morgan CLOIE Index. As of June 30, 2021.
3. Source: J.P. Morgan CLOIE Index. As of June 30, 2021.