Euro CLOs: Comfortable in a tight space
12 June 2017 by Luca Beldi
The recent trend of spread tightening across the fixed income space is also impacting the leveraged loan market, with spreads tightening from 4.8% to 4.25% (Moody’s Analytics) on average over the past year.
Not surprisingly, the more recently issued CLOs are more acutely impacted as they lack a base of more seasoned, higher yielding assets. These new CLOs are forced to buy lower spread assets, with the most recent deals investing with a weighted average spread of 3.8-4.1%. In addition, prepayment speeds are at elevated levels and hence we expect the average spread for 2015-2016 transactions to reduce further.
Over the same period, however, average returns for the equity tranches have remained fairly stable. We have looked at the relevant statistics to understand what is happening to these transactions and how they can still pay the equity with a stable return.
The initial reaction would be that managers must be increasing risk to maintain the same equity pay-out. However, we can see this has not been the case, when we look at the “Weighted Average Rating Factor” (WARF); it has deteriorated slightly but remains relatively comfortably around the B2 rating level. Encouragingly, over the same period we have seen portfolio diversification significantly improve.
Source: Moody’s Analytics
So managers have not added a significant amount of risk, spreads are tighter, but equity yields have been fairly stable? The first factor contributing to this is that default rates of leveraged loans are running at very low levels and even “distressed” assets (priced below 80c on the dollar) are running at the lowest level seen since the financial crisis. The second factor has been managers selling assets, especially fixed rate bonds, that rallied a long way above par that became inefficient for the CLOs. Selling these assets at a premium resulted in a yield boost for the equity tranches. Lastly, and probably the most important factor, has been the ability of CLOs to adjust the cost of the liabilities to the new assets’ environment. Around €15bln of CLOs (source : Morgan Stanley) already repriced their liabilities focusing mainly on the senior, IG-rated part of the capital structure especially the AAA rated tranches that are the main driver of a CLO’s cost of funding, representing on average 60% of the total stack. As a result CLO spreads have tightened 60-250bps over the past 12-months in the AAA to B rated classes; although there remain large differences between managers and between vintages.
This is one of the reason why CLOs were one of our top picks for 2017, and with BBs yielding around L+6% they still deliver attractive returns in a low yield environment without compromising on credit quality. That said we remain cautious on equity tranches, as the arbitrage is thin with little room for error and specific manager selection is now more important than ever!
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