May 24, 2016
Our ABS focus continues to be on CLOs, and the first quarter of 2016 delivered a wild ride for CLO mezzanine tranche investors. Mezzanine tranches of CLOs entered 2016 with an ownership mix composed primarily of hedge funds, Wall Street trading desks, and open-ended mutual funds, with more permanent sources of capital notably absent. Price declines across risk assets in January and February led to outflows, redemptions, margin calls, and management direction to de-risk. Simultaneously, existing mezzanine CLO investors sought liquidity. Without meaningful participation from longer-term investors, such as insurers, banks, and private equity, selling pressure led to a feedback loop of more selling.
Spread compression across mezzanine CLO tranches has occurred without improvement in underlying credit fundamentals. Below-average leveraged loan default rates do not indicate troublesome conditions for loans, but the rising absolute volume of defaults highlights slowly deteriorating credit conditions.
Source: JP Morgan, S&P LCD, Guggenheim. Data as of 3.31.2016.
On the back of dovish comments from the Fed, recovering bank loan prices, and a firming in commodity prices, we observed this feedback loop work in reverse as the quarter ended. Citi CLO Research reported that BB-rated CLOs widened from LIBOR plus 875 basis points at 2015 year end to LIBOR plus 1,150 basis points, but retraced to LIBOR plus 943 basis points in the midst of a breathtaking rally. J.P. Morgan’s CLOIE index for post-crisis CLOs reversed a 2.4 percent loss through the end of February, and ended the quarter down only 20 basis points. April has seen the rally in this market continue. Spreads for post-crisis CLOs are currently in the middle of their 52-week ranges, while pre-crisis CLOs remain at or near their 52-week wides. Subsectors of esoteric ABS held by longer term investors, including whole business ABS, triple net lease ABS, container ABS, and aircraft securitizations, avoided much, but not all, of the price volatility.
The CLO mezzanine recovery has occurred without any meaningful improvement in underlying credit fundamentals or rebalancing of the unstable ownership mix. Defaults and downgrades among noninvestment-grade corporate borrowers that underlie CLOs continue to increase, albeit slowly. We expect the first handful of post-crisis CLOs to divert cash flow away from their equity tranches as a result of performance test breaches. Accordingly, after opportunistically investing during the dislocation of the first quarter, we have slowed our purchase activity in mezzanine CLOs tranches at these higher prices. We have renewed our focus on senior CLO tranches and esoteric ABS, in particular aircraft lease and whole business ABS.
Post-crisis CLO spreads are currently in the middle of their 52-week ranges, while pre-crisis CLOs remain at or near their 52-week wides. We continue to expect that most CLO debt will weather recent market distress without interrupting cash flows, underscoring our favorable view on the market.
Source: JP Morgan, Guggenheim. Data as of 3.31.2016.
—Brendan Beer, Managing Director; George Mancheril, Vice President
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