CLOs: Looking Down the Road to Recovery
Following the sell-off in March and subsequent weakness in April, collateralized loan obligations (CLOs) rebounded materially in May and June, with BBBs up 20.31% and BBs up 36.35% at the end of the quarter.1 The strong rebound for the asset class was driven by a combination of fundamental and technical factors.
JPM CLOIE Tranche Prices
Source: JPM CLOIE. As of June 30, 2020.
From a fundamental perspective, the pace of downgrades to underlying loans has slowed. The default outlook has also improved, alongside the realization that conditions are not as bad as originally feared in late March and early April. Whereas some market participants were originally anticipating defaults of around 10% for the next 12 months, managers are now projecting defaults will more likely be in the 4-7% range for seasoned deals. Forecasts for newer vintage deals are even lower, at 2-3%, given their lower exposure to stressed credits. Further, we are seeing less potential for broad-based cash flow diversion mechanisms to kick in, given the rebound in loan prices and slowing ratings downgrades.
From a technical standpoint, the forced selling that weighed on CLO tranche prices in March and April has now receded, with the asset class benefitting from the liquidity awash in the system as a result of government support programs. Supply and demand dynamics have also grown increasingly favorable, as limited supply is being met with strong demand—much of which has come from large institutional buyers like banks and insurance companies looking for yield in a lower-for-longer rate environment. That said, we have also seen the emergence of opportunistic CLO buyers in the form of new funds aimed at capitalizing on market dislocations, such as what we witnessed following the volatility in March—as BB-rated CLO tranches were trading at heavily discounted prices that appeared to overcompensate for potential defaults.
Despite this rebound, we do not think we’re out of the woods completely. Indeed, a number of potential risks remain on the horizon—from multiple waves of coronavirus cases and further instability in oil prices, to uncertainty around the upcoming U.S. presidential election and sub-optimal projections for second quarter earnings. That said, we believe the most negative scenarios contemplated in March are unlikely to materialize. It is more likely, in our view, that the asset class will move within a range in the coming quarters, as opportunistic buyers exit positions into strength, and weakness is met by investors looking to put fresh capital to work and capitalize on dislocations, given their added comfort that the doomsday scenarios likely won’t play out.
Similar to last quarter, we retain our bias toward quality. We continue to see opportunities in the highest rated (AAA and AA) tranches, while single-A tranches look to have marginally less attractive relative value. We also see opportunities in clean, new issue deals (versus seasoned secondary deals), particularly in mezzanine tranches. In addition to having less exposure to COVID-impacted sectors, these deals tend to have fewer lower-priced assets and greater structural protections. New-issue BB tranches look particularly attractive, in our view, as they have a similar risk profile to seasoned BBB tranches, but offer a more attractive spread premium.
As the pandemic plays out and the U.S. presidential election nears, we expect there to be pockets of volatility that will create relative value trading opportunities. In this environment, we believe active management is crucial to uncovering the best absolute and relative value up and down the capital structure.
1. Source: J.P. Morgan. As of June 30, 2020.