Taryn Leonard and Melissa Ricco, Co-Heads of the Structured Credit investment team, discuss where they're seeing opportunities and risks today—and why technical factors are creating inefficiencies, and hence opportunities, in the current environment.
There is somewhat of a dichotomy occurring in the market at the moment. On one hand, the economy is still in pretty good shape, with low unemployment and slow-but-steady growth. On the other hand, we’ve seen some stress in parts of credit markets. Can you discuss what you’re seeing in the credit markets overall, and in the loan markets more specifically?
Melissa: There is definitely more of a risk-off sentiment in the market today. It’s safe to say that investors are concerned over the state of the economy—whether that’s due to slowing global growth, trade tensions or simply that many believe we’re late-cycle. On the loan side of the equation, idiosyncratic risks are starting to appear more frequently in the market. We’re starting to see large price movements, and concern over downgrades in the low single-B rated part of the market. As a result, there’s been notable bifurcation between low quality and high quality credits, with a bias toward the latter.
Taryn: Loans do appear to be largely out of favor. Investors were very interested in the loan market in 2018, when rising rates were a concern. But once the U.S. Federal Reserve (Fed) pivoted to a dovish tone in the first quarter of 2019, we started to see an exodus out of retail funds—in fact, we’ve seen 13 straight months of outflows. This sell-off created a technical opportunity in the market—and as a result, in some of our broader multi-credit strategies, we’ve started to pivot and add to our exposure in loans. We think they offer a number of potential benefits in the current environment—not only on a yield basis relative to bonds, but also because they are secured assets. Over time, we think loans are well positioned to outperform—and CLOs can be a great way to access the loan market with the added benefits of diversification and structural protection.
That’s a good segue to CLOs. With respect to those structures, can you discuss what you’re currently seeing from a supply and demand perspective?
Melissa: The CLO market has seen impressive supply over the course of 2019—standing at about $100 billion in the U.S. through the third quarter. And the prior two years were even stronger. Taken as a whole, this speaks to the fact that investors across the globe are looking at the asset class as being particularly attractive in a low-rate environment. More recently, we’ve seen supply slow quite a bit. The main reason is that CLO spreads are wide relative to collateral loan spreads, making this a less attractive time to form CLOs from an equity perspective.
From the demand side of the picture, there has been a slight slowdown as well—as investors grow increasingly concerned with credit fundamentals and negative headlines, and shift their focus to the highest-quality portfolios.