The leveraged loan market kept the positive momentum from December's rally to start 2020. Currently, 48% of all U.S. loans are trading at or above par, compared to just 8% in mid-2019. In terms of single B loans, 55% are trading at or above par. Given that single B loans are the largest security type in collateralized loan obligations (CLOs), the market is seeing refinancing volumes increase, creating heightened call risk in deals. The last meaningful wave of loan repricing occurred during 2017 and had a significant impact on an important metric in the CLO market — weighted average spread (WAS). WAS helps generate the amount of excess spread in a CLO in order to pay equity investors after covering their debt liabilities. The CLO market weighted average spread (WAS) fell from 420 basis points (bps) in 2017 to 344 bps by late 2018. Currently, the majority of loan repricing is focusing on BB- and B-rated loans. If the trend continues, we will see lower-rated loans start to reprice, which could drive considerable WAS compression in CLOs.
In order to ensure a CLO portfolio doesn’t become too risky, CLOs typically have collateral quality tests. These tests include a minimum WAS test, a minimum diversity score (DS) test as well as a maximum weighted average rating factor (WARF) test. If any of these tests are deemed inadequate, it can handcuff the ability of managers to trade and reinvest. The collateral quality test matrix is dynamic, with varying levels of allowable WARF based on WAS and DS levels.
Key Takeaway
Given that weighted average spread continues to grind lower due to heavy loan repricing, CLO managers may look to add riskier loans to portfolios in order to pass the WAS test, creating more risk for bondholders. Ongoing credit surveillance of both CLO managers and specific issues is required to successfully navigate potential risks in today’s market. Penn Mutual Asset Management’s deep fundamental approach will continue to focus on the best value opportunities in the CLO market.
The material provided here 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 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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