Focus on Seniority

We anticipate cheaper entry points into mezzanine and subordinate CLO tranches, and esoteric ABS.

May 24, 2016

This sector report is excerpted from the Second Quarter 2016 Fixed-Income Outlook.

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.

Mezzanine CLO Spreads Tighten as Loan Default Volume Edges Higher

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.

Mezzanine CLO Spreads Tighten as Loan Default Volume Edges Higher

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 Move in from 52-Week Wides

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.

Post-Crisis CLO Spreads Move in from 52-Week Wides

Source: JP Morgan, Guggenheim. Data as of 3.31.2016.

—Brendan Beer, Managing Director; George Mancheril, Vice President

Important Notices and Disclosures

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.

Investing involves risk. In general, the value of fixed-income securities fall when interest rates rise. High-yield securities present more liquidity and credit risk than investment-grade bonds and may be subject to greater volatility. Asset-backed securities, including mortgage-backed securities, may have structures that make their reaction to interest rates and other factors difficult to predict, making their prices volatile and they are subject to liquidity risk. Investments in floating-rate senior-secured syndicated bank loans and other floating-rate securities involve special types of risks, including credit risk, interest-rate risk, liquidity risk and prepayment risk.

Guggenheim Investments represents the following affiliated investment management businesses of Guggenheim Partners, LLC: Guggenheim Partners Investment Management, LLC, Security Investors, LLC, Guggenheim Funds Investment Advisors, LLC, Guggenheim Funds Distributors, LLC, Guggenheim Real Estate, LLC, Transparent Value Advisors, LLC, GS GAMMA Advisors, LLC, Guggenheim Partners Europe Limited and Guggenheim Partners India Management.


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