Despite blows from COVID, Fed tightening and, most recently, uncertainty around US tariff policy, leveraged loan spreads have returned to the pre-COVID lows (see Chart 1). In this report, we ask whether the fundamentals support the tight spreads, discuss potential risks and outline how ZAIS CLOs are positioned in this environment.
Source: JPMorgan1
In our view, credit fundamentals remain solid but the share of borrowers with weaker fundamentals has risen, idiosyncratic risks have increased and the tight spreads make it more difficult to identify value opportunities.
This difficulty though, is less of a challenge to ZAIS because we have shifted our focus to defensive strategies.
Table 1 shows credit fundamentals for public and private issuers for the last quarter of 2019, just before the outbreak of COVID, and the most recent available data. Structurally, the debt share of private issuers has increased strongly over the last six years. We attribute that to increased borrowing by private equity firms as well as the rise of private credit.
Source: JPMorgan2
Profitability has in general remained high, but improved somewhat with public issuers and declined a bit with private issuers. Public and private issuers have reduced leverage but that was not enough to offset the rise in effective interest rates, resulting in somewhat lower interest coverage ratios for both issuer types.
In our view, the slippage in interest coverage ratios appears modest, given that interest rates across the curve are 250bps higher now than before COVID.3 More concerning to us is the much lower interest rate coverage ratio for private issuers given their increased share in total debt. This relative weakness of private issuers is also reflected in the much higher share of private issuers with interest rate coverage ratios of less than 2 (see Chart 2).
Source: JP Morgan4
Summarizing, we do not see an across the board deterioration in credit fundamentals: profit margins remain high, leverage ratios have declined and the slippage in interest rate coverage ratios is modest, given the overall rise in interest rates.
However, our concern is that the share of fundamentally weaker credits, especially in the private issuer domain, has increased substantially.
All else equal, we would expect that the rising share of weaker credits should be reflected in overall wider credit spreads and more spread dispersion along the credit curve. The fact is, spreads have tightened over the last six years with less dispersion across the credit curve (see Table 2 below).
This is most evident in the B-rated sector, where roughly two-thirds of new loans are issued. B2 credits are currently priced 112 basis points lower than at the end of 2019. Moving one notch up the credit curve, spreads currently tighten by just 52 basis points versus 98 basis points at the end of 2019.
Moving one notch down the credit curve, spreads currently widen by just 126 basis points versus 249 basis points at the end of 2019.
Source: JPMorgan6
The spread tightening is not the result of low supply. New issuance in 2024/25 is more than double compared to 2018/19 (see Table 3). However, the use of new issuance has shifted from acquisition to repricing, which suggests to us that private equity is struggling to exit deals and forced to extend existing loans.7
In our view, spread tightening amid strong supply is a sign of flush demand, which we observe not just in the leveraged loan market but across all risky asset classes. We do not expect a systemic crisis but we think the leverage loan market has become increasingly vulnerable to idiosyncratic risks given more issuers with weaker credit fundamentals and overall tight spreads.
Source: JPMorgan8
In this environment, we find it difficult to identify attractive relative value opportunities that offer an additional spread to compensate adequately for the additional risk. As a result, we have strengthened our defensive positions in the ZAIS CLO leveraged loan portfolios.
Our defensive portfolio strategy is not just a response to the current market environment but a strategic shift that we have implemented step-by-step over the last four years. The main criteria for our portfolio construction are:
Given increased idiosyncratic risks and less reliable market pricing, full transparency is critical for our assessment of individual issuer’s credit quality. Unfortunately, we find that transparency does not appear to be a top priority for all issuers. We observe that more issuers provide only the bare minimum information and seem to try to avoid the direct dialog with loan investors to provide background information and guidance.
Charts 3 and 4 outline the evolution of the ZAIS CLO portfolio from 2021 until now versus the current universe of CLO managers in terms of:
The two charts show that portfolio strategies and styles vary significantly within the universe of CLO managers. Still, portfolios with lower credit risk scores tend to have lower spreads and higher prices.
*Based on Moody’s credit rating, a lower score means higher rating.
Source: Wells Fargo and ZAIS9
*Based on Moody’s credit rating, a lower score means higher rating.
Source: Wells Fargo and ZAIS10
As part of our strategy overhaul, we have launched a new series of CLOs, called Navesink, which are defensive by design.
The main aim is to minimize losses in the event of credit tests misses and defaults. Since July 2023, we have launched four Navesink CLOs.
Charts 3 and 4 show the positioning of the three existing Navesink funds (green dot) versus the CLO manager universe.
Our aim to build portfolios with low loss probabilities over the long term is reflected in a very low credit risk score (WARF), and appropriate spreads and prices (WAS and WAP).
As a result, we end up passing on more loans rated B3/B- and lower than other CLO managers (see Chart 5 below).
Source: Intex Kanerei and ZAIS11
With most CLO managers positioned in the middle of the credit score spectrum, we believe that our structurally defensive approach of the Navesink CLOs offers value for investors who are looking to buy CLOs for a modest pickup in spread at very low additional risk. We think that the ZAIS Navesink CLOs standout in offering that investment proposition.
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
The information presented herein has been prepared and provided by and is confidential and proprietary to ZAIS Group, LLC and its affiliates and subsidiaries (collectively, “ZAIS”). Accordingly, this material is not to be reproduced in whole or in part or used for any purpose except as authorized by ZAIS, is to be treated as strictly confidential and is not to be disclosed directly or indirectly to any party other than the recipient. By accepting receipt of this document, the recipient agrees to comply with this restriction and confirms its understanding of the limitations set forth in these disclaimers.
Unless otherwise noted, the source of information for the charts, graphs, and other materials contained herein is ZAIS. The charts, tables, and graphs contained in this document are not intended to be used to assist the reader in determining which securities to buy or sell or when to buy or sell securities. Additional information is available upon request.
This information has been prepared solely for informational purposes and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or instrument or to participate in any trading strategy which may or may not be made available. Any such offer of securities would, if made, be made pursuant to definitive final private offering documents, which would contain material information not contained herein (including certain risks) or material that differs from the information contained herein and to which current and prospective investors are referred. Any decision to invest should be made solely in reliance upon such private offering documents. In the event of any such offering, this information shall be deemed superseded, amended and supplemented in its entirety by such private offering documents. Information contained herein does not purport to be complete and is subject to the same qualifications and assumptions, and should be considered by investors only in the light of the same warnings, lack of assurances and representations and other precautionary matters, as disclosed in an applicable private offering memorandum and subscription agreement. No representation or warranty can be given with respect to the terms of any offer of securities conforming to the terms hereof. There is no guarantee that the strategies set forth herein will be successful. The information should only be considered current as at the date specified herein and is subject to change at any time and without notice. Statements made herein that are not attributed to a third party source reflect the views and opinions of ZAIS.
Certain information contained herein represents ZAIS's current reasonable opinion and is based on unaudited and forecast figures which have been derived from multiple sources and have not been subject to specific due diligence. The information has been provided in good faith but is not guaranteed and is subject to uncertainties beyond ZAIS's control and should not be relied upon for the purposes of any investment decision. ZAIS makes no representations or warranties and accepts no liability whether in contract, tort or otherwise for (1) the information not being full and complete, (2) the accuracy of any opinion, (3) the basis on which any comparison has been drawn or the facts selected to make such comparison and (4) the assumptions underlying any opinions. ZAIS does not undertake to update its opinions. No opinion of this nature can be, and this information does not purport to be, full, complete, comprehensive or to contain all relevant information. Statements made herein that are not attributed to a third party source reflect the views and opinions of ZAIS.
These materials may contain statements that are not purely historical in nature but are “forward-looking statements”. In some cases, you can identify forward-looking statements by terms such as “anticipate,” “believe,” “could,” “estimate,” “expect,” “intend,” “may,” “plan,” “potential,” “should” and “would” or the negative of these terms or other comparable terminology. These forward-looking statements include, among other things, projections, forecasts, estimates or hypothetical calculations with respect to income, yield or return, future performance targets, sample or pro forma portfolio structures or portfolio composition, scenario analysis, specific investment strategies or proposed or pro forma levels of diversification or sector investment. These forward-looking statements are based upon certain assumptions, some of which are described herein. Prospective investors are cautioned not to place undue reliance on such statements. No representation is made by ZAIS as to the accuracy, validity or relevance of any such forward-looking statement and the recipient agrees it is solely responsible for gathering its own information and undertaking its own projections, forecasts, estimates and hypothetical calculations. Actual events are difficult to predict, are beyond ZAIS’s control, and may substantially differ from those assumed. All forward-looking statements included herein are based on information available on the date hereof or such date specified and ZAIS does not assume any duty to update any forward-looking statement contained herein. Some important factors which could cause actual results to differ materially from those in any forward-looking statements include, among others, the actual composition of the investment portfolio, any defaults to the investments, the timing of any defaults and subsequent recoveries, changes in interest rates, changes in currency rates and any weakening of the specific obligations included in the portfolio. Accordingly, there can be no assurance that estimated returns or projections can be realized, that forward-looking statements will materialize or that actual returns or results will not be materially lower or higher than those presented. The value of any investment, and the income from it, may fall as well as rise. Accordingly, there can be no assurances that an investor will receive back all or any of the original capital invested. Further, the eligible investments may be leveraged and the portfolio of eligible investments may lack diversification thereby increasing the risk of loss.
ZAIS Group, LLC’s registrations with the Securities and Exchange Commission (the “SEC”) and the Commodity Futures Trading Commission (the “CFTC”) does not imply a certain level of skill or training.