BB CLO tranches are trading at higher yields of 12-18% due to wider spreads and market conditions. Caution is advised on tranches trading towards the higher end of the range. Potential market volatility is driven by economic indicators, inflation, liquidity concerns, and yield curve inversion. However, there are reasons for optimism.
BB CLO tranches are currently trading in a range of approximately +825 to +1500 discount margin. This equates to an all-in yield to maturity of 12-18%.1 Such yield levels represent a considerable rise from the approximately 8% all-in yield levels witnessed in the first quarter of 2022.
The current attractiveness of CLO BBs is supported by Chart 1 which highlights that CLO BB spreads are presently wider than their historical average spread to High-Yield (HY) corporates.
From a relative value perspective, CLO mezzanine tranches are often compared to private credit investments. Currently, there remains a big gap between valuations in public and private credit. While it has narrowed in the last few months, the gap in market valuations as shown in Chart 2 below in the discount to NAV in the publicly listed BDC index is still significant. This implies that legacy private credit assets have not fully repriced.
Although private credit borrowers generally have a close working relationship with one lender that can negotiate a workout more easily than a consortium of lenders, recoveries on troubled small, private borrowers may be low relative to broadly syndicated loans3
We believe that the vast majority of CLO BBs are unlikely to experience impairment of cash flows, even under scenarios of significantly higher collateral losses.
Moreover, these bonds typically trade at a substantial discount to par, thereby offering the potential for even higher holding period returns if spreads retrace to historically average levels. The lowest quartile of BB CLO tranches trade at +1200DM or wider and generally feature a portfolio of higher credit risk loans or have lower subordination due to past credit losses.5
While in most cases these securities are unlikely to suffer impairment, they are more exposed to deterioration in the ratings and prices of the underlying loan portfolios. As a result, we are approaching the higher yielding segment of the BB CLO market with heightened caution at this time given the fragility of the current economic backdrop.
In our view, the return per unit of risk offered by loss-remote CLO BB tranches is compelling today versus other asset classes, particularly for investors with a longer-term holding period and a low to mid-teens return target. However, in looking ahead, we believe that prices on leveraged loans, especially from the riskiest issuers, could become more volatile over the next several months and that it may be possible to achieve a better entry point on subordinate CLO tranches accordingly.
Markets could become volatile for the following reasons near term:
Despite the strength of the labor market, we are observing tightening lending standards, as highlighted in the Senior Loan Officer Opinion Survey (SLOOS). This, coupled with weakness in the Conference Board’s Leading Economic Indicators Index, signals a potential economic slowdown or even a recession by the second half of 2023.
In addition, corporate issuers with near term maturities or stressed capital structures will likely have difficulty accessing the capital markets, which, in turn, elevates the downgrade and default risk for distressed borrowers.
While we believe inflation has likely reached its peak and is now receding, we also anticipate it will remain above the Fed's target due to wage increases in the service sector. Sticky inflation will make it difficult for the Fed to navigate a policy reversal this year. Higher rates for longer is a negative credit factor for leveraged loan borrowers as the resultant declines in debt coverage increase the likelihood of downgrade risk.
Regional bank collapses and the debt ceiling standoff have resulted in a significant infusion of liquidity into the financial system via the US government’s spending down of its Treasury General Account (TGA). However, once the debt ceiling is raised, a liquidity contraction is likely as the TGA must be replenished.
In 2021, after the debt ceiling increased, the S&P 500 declined as the TGA was replenished (see Chart 3). In addition, debt ceiling compromise is likely to include future fiscal austerity which may weigh on risk asset valuations.
We have observed a persistent inversion in the 2s10s section of the yield curve for over a year. Historically, such inversions often precede recessions.
In addition, the Fed’s preferred yield curve measure—the 18-month forward 3-month yield minus the spot 3-month yield—has also turned negative (see Chart 4).7 The latter tends to have more near term predictive power. A near term recession would lead to reduced corporate revenues and a likely uptick in downgrades and defaults.
Despite these indicators of potential economic contraction, we note several reasons for optimism.
Investors have generally been cautious in their positioning, resulting in risk assets being under-owned.
Longer term inflation expectations have remained well anchored, which is necessary for long-term economic growth and market stability.
Such conditions could give rise to a market uplift once greater clarity emerges around economic growth, corporate earnings, the debt ceiling resolution, potential for improvements in productivity and the regional banking sector's health.
While a slowdown in economic growth or a mild contraction seems plausible, we do not foresee a significant decline in economic output. A lack of excess leverage in key sectors of the economy supports this view.
Over the medium to longer term, risk markets are likely to absorb market volatility associated with lower economic growth and eventually retrace higher.
Given that most structured products generate significant cash flow currently, carry will help to mitigate mark-to-market volatility on such investments in the interim.
There is considerable uncertainty in the markets and economy today that may pressure risk markets wider in the near term and thereby create better asset entry points.
Therefore, for investors who wish to consider this asset class, we think it makes sense to pursue a cautious and disciplined approach to the deployment of investment capital as near-term market catalysts are sorted out.
However, as some of the aforementioned issues get resolved, we think the fundamental picture should start to look better and risk markets could see meaningful and lasting upside.
As always, we are available to discuss our views with you. Please contact your Client Relations representative at +1 732 978 9722 or zais.clientrelations@zaisgroup.com
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