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Selective Opportunities in CLOs

13 February 2017 by Aza Teeuwen

It has been a very strong start of the year for risk assets as cash is being put to work but supply has been relatively limited, creating a strong technical backdrop. Within ABS, one of the best performing sectors has been mezzanine CLOs, where spreads have tightened 25-100 basis points for BBB to B rated bonds, and a greater degree of tiering has opened up between managers and vintages. 2013-2015 deals in particular are being priced to mature at the end of their 2 year non-call periods and prices have naturally gravitated towards par.

New and refinanced CLOs are being printed at roughly 3.5-4.0% yield for BBB, 6-7% for BB and close to 9% for single-B rated bonds. However, loan issuance remains subdued hence CLO managers are struggling to ramp up new deals and get the old ones fully invested. For this reason you would expect single-Bs to price wider, as investors are taking the risk that the manager will not be able to ramp the deal efficiently, and it increases the chances of next year’s credit skeletons finding their way into the underlying collateral pool (as Mark wrote about last Friday). Last week CVC priced their new CLO, Cordatus 8, with the underlying portfolio being just 33% of the deal ramped. Although CVC is a very well respected CLO manager, we believe that there is better value in the older CLOs that are currently being refinanced, as the investor has greater transparency surrounding the collateral and there is less exposure to the primary loan market, where yield levels are tight and leave little margin for any market price correction.

We have been selective sellers so far this year in the 2014/2015-vintage BB CLOs (trading at 99-100 with a coupon below Euribor + 550bps), in favour of the 2016 refinanced transactions that are trading close to par with Euribor +650-700bps coupons. The downside in any sell-off is limited as ramping a CLO in the first half of 2016 was attractive, due to the relative value of the underlying loans during that period. This does not take away from the fact that there is a lot of option value in potential call stories. We also recognise the value in selective single-B rated classes, where some tranches are trading at a discounted price in the mid-80s (due to their lower coupons at issuance).

Underlying loan performance has been strong over the past year, aided by general improvement in ratings and a default rate of virtually zero. Despite the rally in the underlying loans, we think CLOs remain very attractive compared to most other fixed income products, with the added benefit of CLOs exhibiting no interest rate duration risk. With no obvious pick-up in leverage loan issuance and limited CLO primary supply, the strong market technical looks set to continue, hence our view that the outperformance of the CLO sub-sector is unlikely to change anytime soo

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