While the vast majority of collateralized loan obligation (CLO) issuance is in floating-rate format and benchmarked to 3-Month LIBOR, this week’s chart highlights the relatively small portion of the market that is issued in fixed-rate format. CLO managers tend to be reluctant to offer fixed-rate tranches. The underlying collateral (leveraged loans) is floating rate, so offering fixed-rate tranches typically requires the use of a swap, which can be costly and not economically sensible for the CLO manager or equity holder. Due to these challenging economics, fixed-rate tranches tend not to be created unless the issuer is pressured to do so. This pressure can take the form of weaker investor demand for CLOs generally. Also, CLO managers that have weaker sponsorship for their deals might be more likely to issue fixed-rate tranches to attract more investors. Furthermore, as this week’s chart highlights, fixed-rate tranche creation tends to be most popular with the AA class, suggesting that of all the classes in the capital stack, the AA class may have the weakest support from investors.
Offering fixed-rate CLOs as a way to increase investor demand for a tranche tends to be successful due to the attractive characteristics of the structure. While it is common knowledge that fixed-rate securities will outperform floating-rate securities during periods of declining interest rates, this week’s commentary seeks to dig a little deeper into the value of fixed-rate CLOs. Some investor types, particularly insurance companies, place value on the stability of cash flows since they may be matching cash inflows from securities to cash outflows for their liabilities. Floating-rate securities tend to be weaker in this area due to the volatility of the underlying benchmark for CLO securities. As an example of this volatility, 3-Month LIBOR started the year at 1.91% and, at the time of writing this article, has since fallen to a level of 43 basis points.
Fixed-rate CLOs also tend to offer dollar price protection during times of market stress. The deep discount floating-rate opportunities currently offered in the market can provide attractive convexity to investors. However, some investors prefer high-carry opportunities, such as what fixed-rate CLO can offer. Scarcity value also offers a strong support to fixed-rate CLO prices. As seen in this week’s chart, fixed-rate issuance for any given rating category is typically in the low single digits as a percentage of the total market. With supply this limited, investors interested in the fixed-rate CLO trade are likely to pay attention and firmly support it when fixed-rate CLOs are offered in the primary and secondary markets.
Key Takeaway
The conditions leading to the issuance of fixed-rate CLOs include the strength of the CLO market, CLO manager tiering and investor sponsorship for a given rated class at the time of issuance. Fixed-rate CLOs offer more stable cash flows due to recent volatility in the 3-Month LIBOR Index. Fixed-rate CLOs also offer dollar price protection during times of market distress, due to scarcity value and outstanding carry amid low-interest-rate market environments.
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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