Between the trade war with China and the dramatic move in interest rates, investors have faced plenty of uncertainty this year. The market volatility experienced last December was widely feared to mark the beginning of a more material downturn. However, despite the market rebound this year, certain signs (most notably the Treasury yield curve inversion) suggest the time to prepare for the next downturn is at hand. Numerous collateralized loan obligation (CLO) managers are rotating out of CCC-rated loans into loans rated BB or B, with data starting to reflect the transition up in quality.
This week’s chart shows key CLO risk metric averages by vintage year (year of origination). Recent vintages are characterized by lower CCC concentrations and higher collateral cushions, with BB market value overcollateralization (MVOC) being used as a proxy for collateral cushion. Moody’s diversity scores have been declining in recent vintages. While increased diversification is typically viewed as a positive, some loan pools could see a decrease in diversification if CLO managers start to avoid certain sectors as they prepare for the next downturn. This could actually be beneficial, as CLO managers try to avoid the sectors that could be hit the hardest if the cycle were to turn.
Weighted average spread (WAS) has remained relatively flat, but has ticked up in recent vintages. This metric is frequently used as a proxy for how much risk a manager is taking. However, spread is what ‘keeps the lights on’ in the CLO world. If managers are rotating out of CCC loans, they may make it a point to ensure that the BB and single B loans they are trading into are on the higher end of the spread spectrum. In practice, however, this is difficult to do, as the managers start getting squeezed for spread as the arbitrage between leveraged loan yields and the cost of liabilities decreases.
This spread squeeze and the heavy supply of B3 rated loans in the primary market are making it difficult for CLO managers to avoid large B-/B3 buckets. This is a risk worth noting, as one of the lessons that investors learned from 1Q16 is that today’s B3 buckets can turn into tomorrow’s CCC spikes in the event of a downturn. Monitoring B3 buckets in a portfolio of CLOs is a good first step. Frequent communication with CLO managers also becomes key. This allows investors to remain aware of the strategies CLO managers are employing to not only prepare for the next downturn, but also to reduce the likelihood of CCC spikes as the credit cycle turns. By employing sophisticated modeling techniques and leveraging strong relationships with CLO managers, it’s possible to detect these B3/CCC problems and avoid managers that are not taking necessary precautions to prepare their loan portfolios for a downturn.
Average CLO metrics for recent vintages suggest that most CLO managers are preparing for a downturn in the near future. As the market approaches the end of the credit cycle, the ability of an investor to evaluate a CLO manager’s strategy in preparing for the downturn becomes crucial.
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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