While many risk assets have rallied so far in 2019, the lower-rated tranches of collateralized loan obligations (CLOs) have lagged. Spreads have even widened as much as 100 basis points (bps) since August, based on our analysis. In the jittery, late-cycle market, some investors are wondering, is this a sign that the credit cycle is turning?
We think the weakness in CLO equity and mezzanine tranches is relatively contained for now. But it does signal that a bifurcation between lower-quality and higher-quality bank loans is becoming more pronounced, and as a result, the weakness in lower-quality CLO tranches is likely to continue. By contrast, valuations in higher-quality loans and AAA CLO tranches currently look attractive, and we expect them to continue performing well.
Hence, careful positioning is essential for investors this late in the cycle.
What is happening?
The bank loan market has undergone a significant ratings migration following some $60 billion in downgrades since 2012, as shown in Figure 1. Single-B issuers and below now make up over 45% of the market, and B− issuers are nearly 15%. The migration has become even more pronounced recently: In October, distressed loans rated CCC and below, currently 6.3% of the market, experienced the largest monthly increase since 2011.
From a performance standpoint, lower-quality loans have significantly underperformed higher-quality loans this year, as Figure 2 illustrates.
We don’t expect a reprieve for the distressed loan segment anytime soon because of weakness in several sectors. First, near-term vulnerability is likely in the pharmaceutical sector stemming from opioid-related litigation and regulatory policy concerns. Second, industries tied to commodity prices, such as oil exploration and production, drilling, and chemicals, may face continued headwinds due to cuts in capex spending amid volatility in oil prices and economic uncertainty. Last, secular headwinds for retailers and certain services companies may be exacerbated by a slowdown in earnings.
Ratings changes can sometimes lag market weakness, and we think further downgrades are likely, which does not bode well for CLO demand.
Impact for CLOs
The divergence in bank loan performance creates a particular challenge for CLO managers. As lower-quality loans underperform and higher-quality names hold up well, managers have limited room to build up trading gains. This means that CLO equity investors are not receiving sufficient current interest to offset the decline in net asset value, which is evident in the trade-off between loan prices and weighted average spreads: Bank loan portfolios backing U.S. CLOs have seen price declines from a high of around $99 in October 2018 to the current $96, yet the weighted average spread for CLO portfolios has widened only a few basis points, from 357 bps over Libor to 363 bps, according to data from Citi.
Moreover, the potential for additional downgrades in bank loans is a concern. CLOs have a limit on how many CCC rated loans they can hold. The median exposure to loans rated CCC and below is currently 5.45% versus a 7.5% maximum for most U.S. CLOs. More bank loan downgrades could further squeeze the room managers have to manage their distressed rating bucket.
Outlook and investment implications
Near term, we believe that the challenges in lower-quality bank loans are idiosyncratic rather than systemic. We expect limited contagion into higher-quality loans or the broader credit markets. We do see further downside risk in lower-quality bank loans, however, particularly those with small tranches, low liquidity, fundamental concerns, and loan-only capital structures. Their weakness will likely have a spillover effect on valuations of lower-rated CLO tranches. As such, we are waiting patiently until valuations become more attractive to deploy capital in this segment.
Demand for CLOs has been weaker in 2019, with issuance down 10% year-over-year (according to JP Morgan High Yield Bond and Leveraged Loan Market Monitor). We expect these trends to continue due to unattractive arbitrage and lack of ready buyers for the equity tranches. Retail buyers’ apathy for bank loans lately, combined with this curtailed demand from CLOs, will likely weigh on bank loan valuations further.
Currently, we see value in higher-quality segments, however, including short-dated AAA CLO tranches and bank loans rated BB and higher, where we can rely on robust bottom-up credit research to ensure strong fundamentals. Also, as an alternative to CLOs, we see opportunities to capitalize on attractive shorter-term financing rates to add modest leverage to a basket of higher-rated, large, liquid loans.
Beth MacLean is a bank loan portfolio manager. Giang Bui is a portfolio manager focusing on CLOs, and Sabeen Firozali is a credit strategist.