August 17, 2016
After a volatile first quarter, improving conditions helped support successful new-issue pricing across a range of esoteric ABS, such as whole business cash flows and aircraft leases, among others. Meanwhile, CLO issuance posted a weak first half, driven by tepid AAA and equity tranche appetite. Japanese AAA CLO buyers reacted to a weaker dollar/yen with wider bids, and fast-money investors, who traditionally leverage AAA CLOs, were reluctant to buy because of margin calls and redemptions during the volatile first quarter. Weighing on demand for new-issue CLO equity is the fact that equity funds and business development companies remain underwater, which interferes with capital-raising efforts. Further, potential equity investors have adopted more conservative default expectations. Finally, limited bank loan supply clouds the prospects for portfolio creation. Ironically, slow CLO creation supports spreads for senior mezzanine CLO tranches. As a result, recently issued AA and A-rated CLO tranches approached their post-crisis tights. In BBB, BB, and B-rated tranches, we see a more nuanced market, with buyers wary of non-pristine CLO portfolios.
CLO new issue volume has been tepid this year largely due to waning demand from foreign investors who have been adversely affected by currency fluctuations, as well as “fast-money” investors still reeling from high volatility at the beginning of the year. The decline in the expected forward path for short-term rates, based on the FOMC’s median fed funds rate projections, has also weighed on demand by lowering all-in yields on CLO investments.
Source: Intex, S&P, Moody’s, Wells Fargo Securities, Guggenheim Investments. Data as of 7.15.2016.
The CLO market gained 1.8 percent on a total return basis in the second quarter of 2016, based on J.P. Morgan’s CLOIE index. Pre-crisis and post-crisis CLOs gained 1.3 percent and 1.9 percent, respectively. Lower-rated CLO tranches outperformed higher-rated tranches, with post-crisis CLOs rated AAA, AA, A, and BBB posting total returns of 1.1 percent, 2 percent, 3 percent, and 7.1 percent, respectively.
We continue to find value in new-issue aircraft lease transactions, and in CLOs backed by loans to middle market companies. In secondary markets, junior mezzanine tranches of certain CLOs are struggling to find price stability, which presents ongoing investment opportunities. Meanwhile, we remain cautious in student loans, marketplace lending (formerly known as “peer-to-peer”), and residential solar ABS. We think investors should apply a higher discount rate to any long-term cash flows that rely upon contested tax or regulatory arrangements, evolving technologies, or unproven consumer credit products. We prefer lending secured by consumer credit products with long track records of repayment performance, regulatory acceptance, and consensus around societal value. Credit extended to businesses and corporations (as opposed to consumers) seems less likely to see regulatory intervention to protect borrowers from their contractual obligations to re-pay lenders.
CLO liability costs (represented by weighted-average CLO coupons) have remained elevated while the rebound in market risk appetite has caused bank loan spreads to compress by almost 100 basis points from the first quarter to the second quarter. As a result, the arbitrage opportunity in CLOs (gauged by the difference between loan spreads and CLO coupons) has declined, contributing to a challenging CLO primary market.
Source: Intex, S&P, Moody’s, Wells Fargo Securities, Guggenheim Investments. Data as of 6.30.2016.
—Brendan Beer, Managing Director; George Mancheril, Vice President
This article is distributed for informational purposes only and should not be considered as investing advice or a recommendation of any particular security, strategy or investment product. It contains opinions of the authors but not necessarily those of Guggenheim Partners or its subsidiaries. The authors’ opinions are subject to change without notice. Information contained herein has been obtained from sources believed to be reliable, but are not assured as to accuracy. Past performance is no guarantee of future results.
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