As macro volatility continued to pummel markets throughout the first quarter, CLOs felt the effects—with dramatic price moves among tranches as investors clamored for liquidity. But we believe that those who invest with an active manager and take a long-term view will benefit.
The coronavirus fallout and other macro-related events, most notably the plunge in oil prices, resulted in volatile price swings across the CLO market over the last month, capping a first quarter that saw some of the largest and fastest market moves ever experienced in structured credit. While risks have definitely increased—especially for BB and lower-rated tranches that are more exposed to deteriorating credit conditions—value opportunities are also rapidly emerging, especially at the top of the capital structure, where higher-rated tranches appear to offer a compelling risk/reward profile for investors with longer time horizons.
Capital Structures Were Repriced from the Top Down
The market-wide clamor for liquidity in mid-March left investors selling their highest quality, most liquid assets across all markets as they rushed to raise cash. In the CLO market, this meant that during the most volatile days, AAA-rated tranches experienced aggressive selling and were significantly marked down in price. As investors saw the new marks on AAA tranches, tranches lower down in the capital structure were subsequently marked down to reflect this. This re-pricing was both a function of investors’ need for liquidity (in the higher-rated portion of the capital stack) and concerns about underlying credit risk (in the mezzanine tranches). Interestingly, during this period of extreme volatility, CLO tranches were quoted by dealers on a dollar basis rather than the normal discount margin convention. This was largely a function of price discovery to help ease buying and selling, but has since reverted to the more typical discount margin (or spread) pricing.
Despite the unusual circumstances, trading never seized up completely during the period. Though markets prices changed rapidly, they did so in a relatively orderly manner—and even on the most challenged trading days, markets saw two-way flow. That said, lower-rated tranches were more difficult to transact in, and a decent portion of mezzanine tranches included in BWIC (bid wanted in competition) lists were ultimately not transacted upon. This was both a function of risk aversion among the buyer base as well as bid/ask spreads that widened to a point that made it difficult for buyers and sellers to find a price at which to transact.
Tranche Prices Move Sizably Throughout March
Source: JPM CLOIE. As of March 31, 2020. Prices shown as a percentage of par.
Value Continues to Lie in Quality
In our view, it is not necessary to take extreme risks to achieve potentially attractive returns in the current environment. Given some of the price dislocations, we are finding good value in the higher quality portions of the capital stack—from AAAs to BBBs. These tranches have seen their prices marked down, in some cases to levels not seen since the Global Financial Crisis (GFC), and given their inherently strong structural protections and low historical default rates, we think they pose a compelling investment opportunity.
With regards to lower-rated tranches (i.e. BB and below), we have somewhat less conviction that now is the time to add significant exposure and expect that better entry points may lie ahead. This is a function of the relative attractiveness of more senior tranches combined with some of the near-term headwinds still facing these lower portions of the capital stack. Given the very uncertain macro backdrop, we expect to see some credit deterioration and an increase in defaults of the underlying loan collateral, which could result in cash diversion mechanics being triggered and potential large scale downgrades on the CLO tranches themselves. Depending on the length and severity of the crisis, S&P estimates that downgrades from BB to CCC- could exceed 50%.1 Regardless of the fact that BB-rated credit buyers are not necessarily dependent on ratings, and the fact that much of this is arguably already “priced in” at current levels, we think these events will inevitably take a toll on market psyche.
It’s important to note that many of the headwinds to lower-rated tranches act as tailwinds for their higher-rated counterparts. For instance, any cash diversion mechanisms that are triggered will re-route payments to the top of the capital structure, further bolstering those tranches. So, while we want to be realistic about the inherent risks in the market right now, we also want to emphasize that the higher-quality portion of the capital structure tends to be resilient, even in times of great distress.
Active Management Remains a Key Differentiator
All of this accentuates the importance of active management, as CLO managers are responsible for selecting and monitoring the underlying loan managers. In terms of steps that Barings is taking to monitor and mitigate the volatility, our structured credit team has implemented a proprietary COVID-19 index, which includes a ‘phase one’ list of names that the team believes to be at risk due to an extreme outbreak of coronavirus. In our view, downgrades will likely happen in two waves—the first occurring among weaker credits (i.e. the hardest hit companies), and the second among names that are balancing on the cusp of a downgrade following the next quarterly earnings release, at which time ratings agencies receive additional information that may prompt downgrades. Industries like airlines, retail, hotels, entertainment and leisure will likely be impacted the hardest, but we can expect to see a much broader range overall. Tracking these names allows us to understand the level of current risk within current portfolios and to make better relative value decisions when evaluating potential buy and sell candidates.
A Continued Focus on Long-term Value
We continue to stay focused on the long-term picture. CLOs are not mark-to-market vehicles—so while the extreme price moves that investors are experiencing today may be unnerving, in many cases, they may prove to just be noise, especially at the top of the capital stack where strong structural protections are in place. In fact, one of the lessons learned during the GFC was that for investors who were able hold on and ride out the storm, the ultimate returns could be quite handsome.
That’s not to say there won’t be risks. We anticipate that increased stress in the real economy will feed through to credit markets in the form of higher defaults and ratings downgrades. It is our job, as active managers, to evaluate and appropriately price this risk. We do expect to see continued price dislocations in this market where, in some cases due to technicals, market prices may overshoot their fundamental value to the downside. It is in these situations—where we aim to identify the best absolute and relative value up and down the capital structure—that we think the value of active management can shine in the months and years ahead.
1 Source: S&P. As of March 31, 2020.