Risk-on, Risk-off & Repeat
Not all CLOs (or CLO managers) are created equal. We know this from experience and the fourth quarter served as a good reminder, as the CLO market swung from its almost panicked state in October to what can be characterized as a “risk on” market to close the year.
This sentiment shift was evident in the BB-rated portion of the market, where spreads on high-quality BB new issues swung from the low-700s (over LIBOR) at the end of September to the low-800s in October—and then retraced this, even pricing tighter than September levels as the year concluded.
U.S. BB-rated CLO Spreads Widened Before Tightening Toward Year-End
Source: JP Morgan. As of December 31, 2019.
A similar story played out in the BBB part of the market, where high-quality deals priced in the 380 range in late September, only to push into the 400s in October, and then back again to end the year.
But it’s not as simple as risk-on, risk-off. Even during the so-called risk-on periods, we have continued to see investors exhibiting a strong preference for “clean” new-issue deals (meaning those with a low proportion of loans trading at stressed levels—typically below $80) versus older, vintage “storied” deals, which may be weighed down by stressed credits, particularly in the energy sector. The pricing in the market has very much reflected this trend, as well as the continued trend of investors preferring deals from perceived high-quality managers—which continue to trade inside of deals from less established players.
Some market players attempted to capitalize on the stress witnessed in the underlying bank loan market last year by issuing CLOs with the ability to invest in a significantly higher proportion of CCC-rated credits, with some managers creating buckets with as much as 25% of the portfolio allocated to them (versus a more typical 7.5%). Our view is that while there may ultimately be some value in the equity tranches of such deals, we would expect to see better entry points.
We do, however, see a variety of opportunities and risks on the horizon. On the risk side, in addition to monitoring credit market conditions for signs of stress, we are closely following the U.S. presidential election. One notable tail risk to be aware of would be if Senator Elizabeth Warren—a strong critic of securitized markets in the past—gains steam, but recent polls show the Senator trailing Vice President Joe Biden and Senator Bernie Sanders by fairly significant margins—though a Sanders win would also hardly be taken well by securitized markets, in all likelihood. We expect to see volatility stemming from election-related headlines throughout the year—but this also tends to be when we find the most attractive value opportunities, and we would expect 2020 to be a similar story.
From an opportunity perspective, we continue to see attractive entry points across the risk-return spectrum, albeit somewhat less attractive than the value we saw and discussed in a recent podcast back in October. In particular, new-issue BB tranches offer attractive value, in our view. Further up the capital stack, AAA and AA-rated tranches also offer value, especially relative to investment grade corporate bonds. We continue to see insurance buyers in this space, and discussed the attractions of these market segments in a recent Viewpoints paper. Finally, as we move further into 2020, we expect to see opportunities arise in secondary equity—where market technicals are driving what we expect to be a compelling value opportunity.
The risk-on, risk-off cycle will likely to continue to play out in 2020—especially with geopolitics in particular focus. So while value opportunities exist and will likely continue to show themselves throughout the year, credit and manager selection will be especially paramount in 2020.