How advanced is the current cycle?
We can debate whether the European Central Bank is behind the curve or not, but Christine Lagarde says rates will be in non-negative territory by September. The ECB is expected to announce both the conclusion of asset purchases and its first interest rate rise in more than 10 years (to come in July) at its policy meeting in the Netherlands on June 9, which added to a presumed second 25bp hike in September would lift Eurozone rates to the dizzying heights of 0%.
And not a moment too soon, with Eurozone inflation running (almost) out of control after accelerating to an all-time high of 8.1% in May. German CPI came in at 7.9% on Monday and with the month-on-month number alone at 0.9%, it is fair to say German savers will want to see rates rise rather higher than 0% in the next several months.
It is no surprise the market is pricing in consecutive 25bp hikes in July and September (there is no August meeting), but if we look slightly further ahead the market projection is for 1.6% worth of rate hikes in the next 12 months, which would bring the base rate to just over 1% by May 2023. That might still seem low, though don’t forget three-month Euribor hasn’t been above 0% since 2015 and hasn’t broken through 1% since 2011 (just ahead of the sovereign debt crisis).
If these ECB hikes materialise as expected, European ABS investors will start getting paid more than they have been for quite some time, since the vast majority of the asset class is floating rate. For most ABS sectors coupons have already gone up slightly since three-month Euribor has already risen (or got less negative) by 0.2% to -0.37% today. Given the AAA notes of most RMBS and consumer ABS transactions haven’t yielded more than 20-40bp over Euribor in recent years, this ‘improvement’ is so far pretty irrelevant (particularly since most coupons are floored at 0%).
If we’re looking for AAA rated asset classes that have paid a meaningful positive income throughout the ultra-low interest rate era, we are left with European CLOs, CMBS and non-performing loans (NPLs). We’ve never been a fan of funding NPLs and the European CMBS market is very small, so the only one of these three trades that investors can do in reliable size is CLOs.
With rates so low, the income from CLO bonds has been pretty much unaffected by changes in Euribor of late, either up or down, as virtually every bond has something called a ‘Euribor floor’ at 0%. So a bond with a Euribor+1% coupon has always paid 1%. There was always embedded value in this floor, but that value is close to zero now and will be completely gone once the ECB has done its first rate hike. Essentially, CLOs will go back to behaving like a proper floating rate asset class. We liked CLOs when there was embedded value in this floor as investors got a 30-50bp pick-up when hedging back into GBP, and as a result CLOs traded tighter than they should on a spread basis. But the recent sell-off and potential for rate hikes has completely changed this again.
AAA rated CLO bonds in particular should now look pretty attractive to any corporate bond buyer concerned about the end of QE. By way of example let’s look at RRME 7, a CLO managed by Apollo issued back in July 2021. The AAA notes of this deal have over 38% of hard structural protection and about 2% of excess margin every year to protect bondholders. To put this 38% in perspective, the historic recovery rate of senior secured corporate loans is 60-70% (as seen during the global financial crisis). With a 60% recovery rate, you can assume that every company in the CLO’s loan pool could default today and AAA bondholders would still get their money back. The bonds have a Euribor+1.02% coupon (with Euribor floored at 0%), around five years to maturity and are currently trading at a spread of around 160bp over Euribor; if we then consider the shape of the forward curve, then the yield is just over 3% in euro and 3.9% in GBP.
In our view, the potential for a 3% yield on a five-year AAA rated euro asset makes CLOs all of a sudden look like rather good value for their risk. Compare that to the current 2.3% yield on the Euro Non-Financial IG index (average rating BBB+, average maturity six years and over five years of interest rate duration) and we can only conclude that one of those is too expensive and the other is too cheap. Clearly the Euro IG index has been heavily supported by the ECB’s QE programmes, but that QE is soon coming to an end.
We think AAA CLOs are screaming value among euro denominated assets, especially when compared to more traditional markets in the rising rate environment we face today.