Structured Credit: AAA Spreads Trend Lower as Tranches Price Tighter

As spreads tightened and managers successfully syndicated AAA tranches, CLOs gained positive traction in the second quarter.

Highlights

Positive Momentum: The CLO market experienced positive returns from tighter spreads during the second quarter. Newly issued U.S. AAA tranches ended the quarter in the low 130s, after starting out in the mid-140s, and BBBs ended around 375 basis points (bps), after beginning in the 390s. The CLOIE returned 1.32% in the second quarter, following a 2.24% return in the first quarter. While not as high, the monthly returns came at a steady pace of 0.52%, 0.57% and 0.22%, respectively.

AAAs Sold Away: One interesting aspect of the recent AAA CLO spread tightening was that it occurred largely without the help of the largest buyer in the market, a Japanese bank—which had, over prior quarters, been able to essentially dictate AAA pricing levels for the market. When the bank stepped away during the first two quarters of 2019, managers who had previously been placing their AAAs with one buyer instead syndicated the tranche. As a result, they were able to sell away from the single tranche buyer, and do so at a tighter (3-5 bps) bid price. This was seen by the market as somewhat of a justification that AAAs could be syndicated to other buyers in the market.

Forward Rates Look Down: Market speculation on future U.S. Federal Reserve (Fed) rate cuts has worked its way into the CLO market, resulting in a flatter forward LIBOR curve and lower bond yields. For example, at the beginning of the quarter, we purchased a AAA-rated CLO at a discount margin of 142 bps, which yielded 3.73%. In June, we purchased a similar quality AAA CLO at a 136 bps discount margin, which yielded 3.24%. Both were priced at par. During that time period, 3 Month LIBOR decreased from 2.59% to 2.35%. Currently the forward curve is predicting that LIBOR will likely end the year even lower, around 2.00%, indicating no relief for lower yields. 

Up in Quality: The quality of the underlying collateral in CLOs has improved over the last year. Key quality metrics—such as WARF (weighted average rating factor), WAS (weighted average spread) and CCC exposure—have all trended positive. The average default rate of underlying loans also remains low, at 0.19%, relative to the broader loan market’s LTM default rate (1.3%). 

Outlook

• In the second half of 2019—with spreads of AAA CLOs trending tighter—we expect to see an increase in CLO resets, as the 2016 and 2017 vintages exit their non-call periods, as well as refinancings.
• Following the drop in 3-Month LIBOR during the quarter, much of the outstanding CLO debt is poised to reset its coupon in July, meaning there will be less interest income for CLO investors to collect during the third quarter.
• On the heels of the Fed’s decision to change course and raise rates at the end of 2018, we saw a rise in retail outflows from floating-rate bank loan funds. This shift in sentiment and demand had knock-on effects for CLOs through May of this year. Because the CLO market never tightened in the first part of the year, it resulted in strong value and allowed the market to outperform in May. We foresee demand increasing alongside potentially lower rates in the second half of 2019.