This week’s chart depicts the quiet focus Moody’s had during 2015 on upgrading Collateralized Loan Obligations (CLO) issued before the financial crisis. CLO 1.0 deals are delevering, wherein senior tranches are paying down principal, which leads to improving credit enhancement for mezzanine tranches. Many of the deals are locked out of reinvestment, which makes the pools static and mitigates manager risk. Valuations in the space have been supported by relatively short weighted average lives (even when modeled to maturity). Additionally, the cash distributions and calculated returns to equityholders make it more economic to call certain deals sooner rather than later (benefitting CLO performance for purchases below par).
However, idiosyncratic risk in the energy and commodities sectors came to a head in February this year, and the overall CLO sector continues to face a number of headwinds. Issuance continues to be a fraction of what it was this time last year, and managers are still struggling with the new regulatory landscape. Risk retention requirements are forcing a number of managers – even strong, prolific ones in some instances – to put themselves up for sale. Credit cycle concerns are not at the feverish pitch they were in February, but the high yield markets continue to feel the pain in the energy sector. Additionally, the retail sector continues to pose some concern due to increasing competition from online retailers.
Key Takeaway:Despite headwinds, I believe there are still attractive investment opportunities in the seasoned CLO sector. The deals continue to delever and become more callable as senior tranches pay down. Rating agency upgrades have slowed due to the numerous and more prominent risks facing the sector this year. However, seasoned CLO rating actions remain overwhelmingly biased towards upgrades, while the overall corporate bond market experiences the most downgrades since the financial crisis.
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This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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