CLOs: Opportunities in the Tranches

These are neither the best nor the worst of times for credit-market investors, but they certainly are trying times. With recession a looming worry and major central banks intent on tightening, credit investors have reason to be concerned about potential principal losses from rising rates and a higher percentage of defaults. One asset class, collateralized loan obligations, or CLOs, may help buffer today’s risks and offers a variety of ways to potentially benefit from current conditions.

The complexity and flexibility of the CLO structure – with investments available in tranches across the entire capital stack – is suited to today’s environment because it affords opportunities for conservative investors as well as those with more aggressive risk appetites to select an investment profile that suits their requirements and risk tolerances.

CLOs Offer a Competitive Risk Profile, With Attractive Risk-Adjusted Returns Versus Other Asset Classes

Source: Morningstar. CLOs represented by J.P. Morgan CLO Index; AAA Rated CLOs represented by J.P. Morgan CLO AAA Index; AA Rated CLOs by J.P. Morgan CLO AA Index; A Rated CLOs by J.P. Morgan CLO A Index, BBB Rated CLOs represented by J.P. Morgan CLO BBB Index, BB Rated CLOs by J.P. Morgan CLO BB Index; US IG by ICE BofA US Corporate Index; US HY by ICE BofA US High Yield Index; Agg by the ICE BofA US Broad Market; US IG FRNs by MVIS US Investment Grade Floating Rate Note Index; Leveraged Loans by Morningstar LSTA Leveraged Loan 100 Index. Past performance is not indicative of future results. This is not an offer to buy or sell, or recommendation to buy or sell any of the securities mentioned herein.

For example, investors in the investment grade market who are anxious about rising interest rates are likely to find senior-level tranches of CLOs appealing. These top-most tranches, rated AAA or AA, are owned mainly by insurance companies seeking income and banks that need high-quality capital. The current attraction of these CLO tranches lies in their floating-rate nature and yield. If interest rates keep rising, as is widely expected, the coupons on the CLO tranches — unlike those of comparable fixed-rate investments — will rise as well. At the same time, the prices of floating-rate bonds will not experience the same magnitude of decline as fixed-rate instruments issued with low coupons, such as what we have observed in the Treasury, investment grade, or high yield markets.

CLOs Have Historically Outperformed in Rising Rate Environments

Source: VanEck, Morningstar, and JP Morgan as of 30 June 2022. CLOs are represented by the JPM CLOIE Index, US Treasury by the ICE BofA US Treasury Index, US IG by the ICE BofA US Corporate Index, and US IG FRN by the MVISUS Investment Grade Floating Rate Index. Past performance is not indicative of future results. This is not an offer to buy or sell, or recommendation to buy or sell any of the securities mentioned herein.

Because the senior tranches are first in line for payment and CLO holdings in general are highly diversified, default risk for the senior tranches would likely remain low even in the event of a recession. Notably, no AAA or AA rated CLO has defaulted and experienced a resulting loss in the almost 30-year history of Moody’s rating CLOs.

CLOs Have Offered Attractive Historical Returns Versus Other IG Fixed Income

Source: VanEck, Morningstar, and JP Morgan as of 30 June 2022. CLOs are represented by the JPM CLOIE Index, US IG FRN by the MVISUS Investment Grade Floating Rate Index, US IG by the ICE BofA US Corporate Index, and Agg by the ICE BofA US Broad Market Index. Past performance is not indicative of future results. This is not an offer to buy or sell, or recommendation to buy or sell any of the securities mentioned herein.

The severity of any slowdown or recession that may emerge is difficult to predict given the ongoing strength of the labor market and corporate earnings that continue to exceed expectations. Nevertheless, for mezzanine tranches of CLOs, generally rated A, BBB, and BB, a recession would likely increase default risk to a greater degree than in the very low-risk senior tranches. But even though we anticipate some credit downgrades and a rise in defaults in the months ahead, we do not anticipate a surge by any means, and any rise would be off a very low base.

Currently, the default rate in CLO portfolios is 0.3%, which is very low by historical measures. For 2022, the default rate could rise to around 1.5%. Should a recession arrive next year, we believe corporations’ generally healthy balance sheets should keep the default rate within the 2.5%-3.0% range. With BBB rated and BB rated CLO tranches priced attractively and yielding approximately 7.8% and 11.9%, respectively, many investors may find that the yields more than compensate for the risk.

At the base of the CLO stack lies the equity tranche, which currently has the most varied profile in the asset class. Investing in the equity tranche involves direct exposure to defaults and losses in the CLO – so selecting a transaction, manager, and vintage are some key variables that must be taken into consideration when making an investment decision.

Overall, we do not view secondary market CLO equity as particularly attractive amid current market conditions. In the US, while the underlying leveraged loans have been resetting to higher rates, which is positive for CLOs in general, this has created issues for the equity tranche. Leveraged loans have moved through their Libor floors, which had been a benefit but are now a headwind. Additionally, the one- and three-month Libor basis has increased to historical wides. Amid these challenges, July equity distributions were down by as much as two percentage points. We expect these headwinds to continue in the US before abating in 2023. While European CLOs have been seeing less basis pressure, the European Central Bank’s move to raise rates could put pressure on the economy and spur a resulting increase in defaults of the underlying loans.

On the other hand, the current challenges for secondary market CLO equity make prospects for primary CLO equity issuance attractive under certain circumstances. With the underlying leveraged loan market having sold off and now in the mid-90s, the discount to par at that pricing level represents a potentially attractive opportunity for buyers of newly constructed equity tranches. We would view any further weakness in the leveraged loan market as an attractive opportunity. Primary market investors taking positions in new equity tranches consisting of a CLO structured to be called in the next few years may have the potential to enjoy substantial capital appreciation as their package of assets rises to reach par in the future.

Where should investors look for opportunities in CLOs? Currently, tranches above the equity slice and especially closer to the top of the capital stack are looking more attractive to us, offering greater protection in the unlikely event of losses and benefiting from floating interest rates on the tranches as rates rise. That said, CLOs offer a range of solutions to meet the particular challenges a given investor may face in the current environment. The chief challenge for all CLO investors, in fact, may be the need to respond quickly to opportunities that seem to be appearing and then dissipating faster than ever.