In stocks, the ‘January Effect’ refers to a seasonal phenomenon where stock prices tend to increase during the month of January, but it’s common to hear this behavior applied to various fixed income sectors as well. As the collateralized loan obligation (CLO) market faced a nasty bout of volatility toward the end of 2018, the media seemed to continuously disparage the soundness of investments in CLOs and leveraged loans. More often than not, market participants discussed the potential for a January Effect to gallop to the rescue and save the CLO market from another 1Q16.
With enough post-crisis data in J.P. Morgan’s popular CLO Index (CLOIE), putting this hypothesis to the test is somewhat straightforward. This week’s chart outlines CLOIE AAA average spread moves by month going back to 2012. After plotting the data, it became clear that: 1) there is some first quarter seasonality that could benefit holders during that timeframe, and 2) there’s some indication that dealer balance sheet constraints toward year end could have a negative effect on spreads during that timeframe. Analysis of all the other indices for AA through BB CLO yielded similar results.
Maintaining an index for a structured credit sector with low transparency is no easy task. The index team must absorb enormous amounts of data from CLO auctions (a.k.a. BWICs, or bids wanted in competition), primary market issuance, dealer inventories and out-of-competition transactions. They must then synthesize all of this data and merge it with their pricing models in order to ensure a thorough process that includes fundamental analysis supported by technical market color. Investors may occasionally disagree with the levels provided by the index, but they also have the opportunity to share market color with the index team, which can improve index accuracy.
At the start of a new year, the market for structured credit sectors with less transparency can be somewhat slow to develop, for a number of different reasons. Some issuers may have rushed to get deals done before the end of the prior year, thus leading to a slight decrease in primary market issuance for January. A lot of portfolio clean-up selling in December can also lead to reduced BWIC supply in January. The increased uncertainty in spreads that arises from this hiccup in supply can lead to a decrease in investor demand, as investors wait for more clarity on the magnitude and direction of spreads before deploying capital. However, this week’s chart suggests that once this clarity is received, investors are quick to get back into the market.
Key Takeaway
Historical CLOIE data for AAA spread activity over the past seven years were reviewed and graphed to determine if a material January Effect exists in CLO AAA spreads. There is some indication of seasonality in the results, including spread tightening in the first quarter and perhaps some spread widening in the last quarter. Analysis of historical spreads in the AA through BB tranches yielded similar results. CLO issuance and BWIC trends in December can lead to lower supply in January, creating uncertainty about where spreads should be during the first or second weeks of the year. This uncertainty can lead to a decrease in investor demand, as investors wait for spread clarity. Once spread clarity is received, this week’s chart demonstrates that investors can be quick to re-enter the market.
Index Definition:
J.P. Morgan Collateralized Loan Obligation Index (CLOIE) - A benchmark to track the market for U.S. dollar-denominated, broadly-syndicated, arbitrage CLOs.
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