Public Fixed Income

Deja vu for CLOs?

July 2021 – 3 min read
Heavy supply around quarterly payment dates has led to predictable periods of spread widening in the CLO market—creating attractive relative value opportunities up and down the capital structure.

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.

Taryn Leonard

Co-Head Structured Credit Investments Team

Melissa Ricco

Co-Head Structured Credit Investments Team

Any forecasts in this material are based upon Barings opinion of the market at the date of preparation and are subject to change without notice, dependent upon many factors. Any prediction, projection or forecast is not necessarily indicative of the future or likely performance. Investment involves risk. The value of any investments and any income generated may go down as well as up and is not guaranteed by Barings or any other person. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

Any investment results, portfolio compositions and or examples set forth in this material are provided for illustrative purposes only and are not indicative of any future investment results, future portfolio composition or investments. The composition, size of, and risks associated with an investment may differ substantially from any examples set forth in this material No representation is made that an investment will be profitable or will not incur losses. Where appropriate, changes in the currency exchange rates may affect the value of investments. Prospective investors should read the offering documents, if applicable, for the details and specific risk factors of any Fund/Strategy discussed in this material.

Barings is the brand name for the worldwide asset management and associated businesses of Barings LLC and its global affiliates. Barings Securities LLC, Barings (U.K.) Limited, Barings Global Advisers Limited, Barings Australia Pty Ltd, Barings Japan Limited, Baring Asset Management Limited, Baring International Investment Limited, Baring Fund Managers Limited, Baring International Fund Managers (Ireland) Limited, Baring Asset Management (Asia) Limited, Baring SICE (Taiwan) Limited, Baring Asset Management Switzerland Sarl, and Baring Asset Management Korea Limited each are affiliated financial service companies owned by Barings LLC (each, individually, an “Affiliate”).

NO OFFER: The material is for informational purposes only and is not an offer or solicitation for the purchase or sale of any financial instrument or service in any jurisdiction. The material herein was prepared without any consideration of the investment objectives, financial situation or particular needs of anyone who may receive it. This material is not, and must not be treated as, investment advice, an investment recommendation, investment research, or a recommendation about the suitability or appropriateness of any security, commodity, investment, or particular investment strategy, and must not be construed as a projection or prediction.

Unless otherwise mentioned, the views contained in this material are those of Barings. These views are made in good faith in relation to the facts known at the time of preparation and are subject to change without notice. Individual portfolio management teams may hold different views than the views expressed herein and may make different investment decisions for different clients. Parts of this material may be based on information received from sources we believe to be reliable. Although every effort is taken to ensure that the information contained in this material is accurate, Barings makes no representation or warranty, express or implied, regarding the accuracy, completeness or adequacy of the information.

Any service, security, investment or product outlined in this material may not be suitable for a prospective investor or available in their jurisdiction. Copyright in this material is owned by Barings. Information in this material may be used for your own personal use, but may not be altered, reproduced or distributed without Barings’ consent.

Related Viewpoints