Coming off a tumultuous year, CLOs look well-positioned going forward—particularly if the economy continues to heal and rates move higher.
Collateralized loan obligations (CLOs) staged a strong comeback after experiencing the most dramatic decline in recent history—ending the year very close to where they began.
After declining as much as 40% at the onset of the pandemic, CLOs rallied back to end the year in positive territory, with AAA, AA and single-A tranches up 2.54%, 2.97% and 4.64%, respectively. BBB, BB and single-B tranches also delivered positive performance for the year, at 5.47%, 8.04% and 6.22%.1 In the fourth quarter, despite getting off to a slow start, performance was largely driven by news of the vaccine, which eclipsed concerns over rising COVID cases and buoyed risk-on sentiment. Across the capital structure, spreads reached post-COVID tights.
FIGURE 1: JPM CLOIE TRANCHE PRICES
Source: J.P. Morgan CLOIE. As of December 31, 2020.
Fundamental, Technical Pictures Improving
From a fundamental perspective, the picture is certainly improving. For one, the pace of downgrades to underlying loans has all but stopped, and was far less severe than some market participants were forecasting. Default expectations, too, have come down materially from the double-digit expectations at the onset of the pandemic, with forecasts over the next 12 months in the range of 3-5%. In our view, CLOs are well-equipped to withstand defaults in this range, due largely to their robust structures and strong credit enhancements, particularly in the higher-rated tranches. Going forward, we do not expect defaults to reach a point where they run the risk of impacting even lower-rated BBB (and most BB) CLOs at a principal level.
The technical backdrop also continued to improve. Supply and demand dynamics remained supportive, as elevated issuance was well-absorbed by the market—particularly AAA tranches, which met continued strong demand from institutional buyers looking for yield. Also on the technical side, investors have continued to build up cash since the beginning of the fourth quarter, anticipating further bouts of volatility and a chance to invest at potentially wider spread levels. But as news of the vaccine continues to buoy markets, the volatility has yet to fully materialize. At the same time, many investors have received, or will receive, their quarterly interest payments, further contributing to the amount of cash sitting on the sidelines.
Going forward, despite near-term risks from rising COVID cases and a contentious political backdrop, there seems to be a clearer path to the reopening of the economy. Against this backdrop, there is an asymmetry of outcome in terms of where rates can go—namely, rates look more likely to increase than decrease over the next 12-24 months given the more positive outlook for growth. A rising rate environment can be beneficial for asset classes like loans and CLOs given their floating-rate coupons, which lower duration, or interest rate, risk. As a result, prices on floating-rate assets tend to be more stable in a rising rate environment compared to some fixed rate asset classes, which can also contribute to lower volatility.
In the near-term, however, the low-rate environment has created an interesting opportunity in CLO equity in particular. As rates have remained near zero—at least until the last week or so—there has been an increase in the number of new issue loans coming to market with LIBOR floors—limits that are sometimes put in place in near-zero rate environments to ensure investors receive a minimum return. When there is a large concentration of underlying collateral with the benefit of a LIBOR floor and CLO liabilities priced near zero due to low benchmark rates, the difference is captured in the form of flows to the equity tranche. In our view, this dynamic provides a supportive backdrop for CLO equity, particularly given the improving downgrade and default picture.
Selectivity is Key
As a result of the CLO market’s strong comeback and positive backdrop, valuations currently look somewhat rich relative to much of last year. That said, in today’s low-yielding and lower-for-longer rate environment, we expect demand to persist given that CLOs continue to look attractive from a yield perspective compared to other segments of the market. However, credit and manager selection are—and will continue to be—paramount when it comes to generating alpha going forward.
For instance, risk-remote AAA and AA tranches look attractive given their position at the top of the capital structure—but there can be a significant spread differential by manager type. As an example, new issues from strong, Tier 2 AA managers have continued to offer attractive spread pick-up versus deals from Tier 1 managers. We also see potential opportunities in select deals with longer (five-year) reinvestment periods. Further down the capital structure, we continue to see value in new issue BBBs given the potential for volatility on the horizon. While we also see select opportunities in new issue and high quality secondary BBs, spreads have tightened quite a bit and new issue discount has virtually disappeared. Thus, given the aforementioned technical backdrop—and with cash continuing to build up—there may be more attractive entry points down the road.
In an environment where positive news surrounding the vaccine is interspersed with negative headlines around rising COVID cases and heightened political tensions, we expect pockets of volatility to emerge and potentially create relative value trading opportunities. However, given that we likely still have a long road to recovery ahead of us, careful, bottom-up credit and manager selection are key, both to selecting the right opportunities and avoiding unnecessary risks.
1. Source: J.P. Morgan CLOIE Index. As of December 31, 2020.