This Cycle’s Low Yields Are Behind Us
It’s been an interesting week for European CLOs; one of our favourite picks in fixed income.
Credit fundamentals are strong; the senior secured loans backing these transactions showed the lowest post-crisis default rate in May (Source: S&P European Leveraged Loan Index) and even assets rated CCC are declining with the median across observable deals below 2%. Looking at the most volatile parts of the market at the moment, Spanish and Italian exposure of these pools of loans is below 6% for the vast majority of deals (Source: Morgan Stanley research, 6th June). On top of the collateral performance CLOs also provide structural protection against losses and credit enhancement levels, even at the most junior end (single B rated) are stable in the 7-8% range depending on the deal.
So why are we focusing on them once again? As we anticipated in our previous blog volatility has leaked into this section of the market as well, mainly for bonds rated below single-A. As a result, spreads have widened around 25bps for BBB-rated bonds, and around 50bps for single-B rated tranches in the last couple of weeks.
The reasons for these moves are to be found in the technicals of the market: the bonds are floating rate so they are not impacted by rates moves but the first half of 2018 saw a post crisis record of primary issuance and the pipeline doesn’t show any sign of slowing down, with deals piling up to price ahead of the summer slowdown in activity. This has led to a temporary degree of indigestion and pushed spreads wider as deals compete for investor attention. This has an elevated effect in CLOs as there is a smaller investor base that has the knowledge and experience to analyse these complex products, especially at the junior end leading to the current weakness.
We see improving fundamentals and yieldier assets as creating good relative value in the credit space. This has been confirmed by increased participation by investors from across the Atlantic, as these spread levels allow them to pick up some yield when hedged back to USD when compared to similar assets domiciled in the US and gain exposure to a region where the cycle is in a less advanced stage.