After what seemed like a promising recovery in the first four months of 2019, leveraged loan prices have exhibited a downward trend since May. This has negatively affected market value coverage of collateralized loan obligations (CLOs). This technical weakness, combined with some fundamental deterioration in certain leveraged loan names, has increased investor fear in the leveraged loan/CLO space. However, a broad range of institutional investors understand the risks associated with the sector and remain dedicated to the CLO space.
For those still pursuing relative value opportunities in the asset class, this week’s chart reveals an interesting technical dynamic in CLOs. Operating under the assumption of a reversion to the mean, the basis between CLO rating categories can be an important aspect of any relative value assessment. The chart highlights that spreads between rating categories (e.g., AA-A) are wider than recent averages. An increase in these so-called basis differentials as investors move down in credit quality throughout the capital stack is an indicator of investor risk aversion toward the asset class as a whole. However, it also represents a potential catalyst for spread tightening in the event of near-term market stabilization in leveraged loan valuations.
CLO spreads are ultimately driven by underlying credit fundamentals. Bonds rated CCC have materially underperformed BB-rated bonds. Given the heightened risk in lower-rated high yield bonds, the fundamental weakness has leaked over to leveraged loans as well, despite their seniority in the capital stack. Leveraged loans rated B3/B- have a higher probability of being downgraded to CCC or lower, which impacts the market value coverage in CLO tranches. Additionally, 3-month LIBOR has seen a 32% decline on a year-to-date basis, causing some investors to shy away from floating-rate securities.
Technical volatility and some fundamental weaknesses remain in the leveraged loan space. However, for investors who are still dedicated to the sector, there are some interesting relative value opportunities to move lower in credit quality in CLOs with strong credit metrics and highly rated managers. Penn Mutual Asset Management employs a deep fundamental approach to credit analysis in order to help identify the best relative value opportunities given current market conditions.
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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