Before we kick off the first Chart of the Week for 2023, we want to wish everyone a Happy New Year and hope everyone enjoyed the holidays with those closest to them. The previous year was certainly eventful for fixed income markets. The Federal Reserve (Fed) raised its policy rate from zero to 4.25-4.50%, defying expectations at the start of the year that it would increase rates to 0.75%.1 Treasury yields, mortgage rates, and credit spreads all ended the year at higher levels than most investors were forecasting.
For this week’s Chart of the Week, we are taking a more nuanced look into the nearly $1 trillion U.S. collateralized loan obligation (CLO) market. A CLO is a managed pool consisting primarily of leveraged loans that is securitized and sold as debt tranches to investors. While the quality and performance of a CLO’s leveraged loan pool impacts the performance and price of its debt tranches, the CLO market transacts with CLO managers being unofficially placed into several tiers by market participants. A manager’s tier can also impact the prices investors pay for its CLO debt. A CLO manager’s strategy and performance will impact what tier the market places it in, however other factors such as manager size and assets under management (AUM) play an important role.
The green line on the chart shows the spread, or discount margin (DM), for AAA-rated CLO while the orange line shows the spread dispersion between AAA CLO debt between the 75th and 25th percentiles – both of which widened in 2022. Most AAA CLOs carry 36-39% credit enhancement, and while the macroeconomic environment has declined over the past year, it is unlikely that credit risk for AAA CLO is what is being priced by wider spreads for lower-tier managers. What is more likely is that wider dispersion in AAA spreads is reflective of liquidity for a CLO manager’s debt. CLOs from larger, top-tier managers are likely sponsored by a larger investor base, and tighter spreads for debt from those managers may be warranted by the ability to find liquidity in times of heightened stress and volatility.
Key Takeaway
Spread dispersion across CLO managers widened in 2022. While the widening was more pronounced for lower-rated tranches which may be more reflective of credit risk, widening for higher-rated tranches is more likely reflective of liquidity risk. The extra spread being earned from buying investment grade CLO debt from wider-trading managers may look attractive for buy-and-hold investors versus “paying up” for top-tier names. Additionally, top-tier managers are likely to have more flexibility managing a CLO and can utilize looser post-reinvestment period rules to keep a CLO outstanding longer. With the majority of CLOs trading at a discount, the ability (or lack thereof) for a manager to reinvest principal proceeds versus using them to pay down debt tranches can impact the returns for CLO debt.
Sources:
1Source: AP- Fed Raises Key Rate by Half-Point and Signals More to Come; 12/14/22
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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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