CLO Rally Flirts With Post-Crisis High as Risk Premiums Tighten

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Collateralized loan obligations are rallying the most in three years as money managers rotate into floating-rate securities as Treasury yields creep higher.

Risk premiums for new bonds, which package and sell leveraged loans into tranches of varying risk and potential return, are the tightest they’ve been since 2018, according to data compiled by Bloomberg. Moreover, they are poised to bust through a key post-crisis level not seen since February 2018.

The strong showing has prompted managers to bring new deals at favorable terms and refinance and reset existing bonds at cheaper costs, leading market observers to predict a record year for refinancings.

The spread tightening has been key in improving the so-called arbitrage -- the gap between the interest earned from the underlying leveraged loans and the cost of borrowing to purchase the assets. A healthier arbitrage enhances the economics of the transactions, which makes it easier to attract CLO equity capital to sponsor new deals.

CLO Rally Flirts With Post-Crisis High as Risk Premiums Tighten

“We believe that the arbitrage has gotten much more attractive in today’s market -- it’s more compelling relative to the last few years,” Deep Maji, head of CLO investing at Oxford Funds, said in an interview. “We’ve seen some AAA prints inside of Libor plus 110 basis points whereas, during the worst of the pandemic, we saw new-issue AAAs in excess of Libor plus 200.”

Boats Rising

Top-tier CLO issuers tightened their senior tranches inside of 105 basis points so far this month, and market observers say it could break below 100 basis points, tempting the cheapest level for issuers since the Great Financial Crisis.

In February 2018, CLO managers Ares Management and New York Life hit post-crisis milestones, achieving AAA spreads below 100 basis points for the first time since the Great Financial Crisis. Ares hit the record of 92 basis points while New York Life was close with a 95 basis point print.

Even deals with traditional characteristics such as five-year reinvestment periods and two-year non-calls, which were temporarily sidelined during the pandemic selloff, are in on the rally. Barings LLC and CIFC Asset Management each landed AAA tranches at 102 basis points over Libor, and Neuberger Berman looks poised to do the same next week, according to data compiled by Bloomberg.

Bank Demand

A rise in bank demand for CLOs rated AAA has also helped compress spreads in the primary market, according to Morgan Stanley. Bank participation appears broad-based from both large money-centers and smaller regional firms and some may be looking beyond the AAA-rated portion of the stack, analysts said in a Thursday research note.

The institutions are sitting on a pile of cash as quantitative easing and stimulus is boosting deposit growth “to stratospheric levels,” Morgan Stanley analysts led by Charlie Wu said.

The CLO market has been buoyed by higher demand for floating-rate debt as many market participants expect rates to continue rising, making fixed-rate bonds less attractive. Last year the market was helped by support from the Federal Reserve to the riskiest companies -- those that issue leveraged loans -- as well as portfolio managers trading out of perilous credits, protections built into the deals and a lower number of loan defaults than anticipated.

Read more: Floating-rate notes are growing more popular as yields rise

The recovery in securitized credit overall, which includes CLOs, generally lagged that of corporate bonds last year, making the sector an appealing source of relative value for investors. After widening after lockdowns started a year ago, CLO spreads mostly tightened to pre-pandemic levels by December. Wall Street predicts a rise in sales in 2021.

Relative Value: ABS

  • Student loan ABS spreads have tightened in 2021, Deutsche Bank AG analysts said in a recent research note
  • Compared with the other main ABS asset types, SLABS senior spreads have seen more tightening year-to-date, coming in an average of five basis points across the curve for FFELP and 12 basis points for private credit SLABS
  • When comparing current levels with 2020 wides, the tightening seen in FFELP SLABS still lags behind autos and cards, the analysts noted
  • DB thinks FFELP could see continued incremental tightening, as the extension of Libor’s end-date through mid-2023 should ease near-term pressure on the sector

Quotable

“There is such a massive shortage of single-family housing in the country overall -- both new construction and fix-and-flip. It’s all under pressure and Covid has made it worse,” said Curt Altig, chief executive officer of Seattle-based real estate lender Builders Capital. “People are not reselling at the level they otherwise would be. There is fierce competition for a reduced volume of houses on the market. But the world is awash in capital looking for yield, so rates continue coming down.”

What’s Next

ABS deals in the queue for next week include JPMorgan Chase (prime auto linked note), Element (auto fleet lease), Navient (private student loan refinancings), and Stack Data Centers (data services ABS).

©2021 Bloomberg L.P.

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