There is a great article that Bloomberg posted just before the holiday titled “CLOs Cracked Like No Other Market. So Now What?” By Brian Chappatta. In a nutshell the article points out that the prices on the double B tranche for CLOs fell to the lowest level in more than 3 years, and oddly as their yields widened out significantly (110 bp in 6 weeks), the spreads on double B individual corporate loans actually tightened 43 bps. This is counterintuitive and the article goes on to suggest that much of this differential is attributable to the CLOs double Bs position within the debt stack.

I think the assessment was spot on but I wanted to point out a few other variables that might also be at play.

  • First, a CLO double B is a very different animal than an individual corporate issuer that is rated double B. Comparing spreads between these two debt instruments may be useful from a reference perspective, but they are not apples to apples. There are a lot of different risk factors that go into the CLO double B that have nothing to do with an individual corporate borrower.
  • Second, there are many different types of buyers of individual corporate double Bs, therefore, there are lots of shops out there formatted to analyze corporate credit. There are fewer investors capable, qualified or sophisticated enough to analyze and buy a CLO double B. A limited buyer universe is never a good thing when it comes to a credit risk instrument.
  • Third, double Bs are a very small component of a CLOs overall “capital structure” (appx 3-5% of the overall structure). This is a problem for two reasons; smaller size means a smaller universe of potential buyers and a smaller pool of buyers means less efficient price action, especially in times of stress when both relative and individual asset prices are under pressure. Since risk migrates up the cap structure from the equity, the next stop in a CLO is the Double B (sometimes single B) tranches. As the author points out, the lower end of the CLO capital stack bears the brunt of the risk which basically ties into the next point.
  • Finally, there is the spectre of credit quality. Over the past few years there has been a significant decline in the amount of protections afforded to lenders that have gone by the wayside. There is no doubt that the amount of credit risk in the system is higher than ever before. How this plays out remains to be seen but I think it’s safe to say that it will result in more losses than in years past (with respect to recoveries) and as a result, the lower end of the CLO capital stack could see a bumpy ride.

So to recap, yes, I think the bulk of that spread differential is related to the potential volatility in the CLO double B resulting from the increase in credit risk introduced into the system by laxed credit standards. The liquidity related variables that permanently plague the loan and CLO markets cannot be overlooked. I am not surprised by the inverse spread relationship given a limited universe of buyers sophisticated enough to buy them. It is a relatively small instrument further reducing the universe of potential buyers for a higher-octane instrument.

In closing, let me leave you with this thought. If you boil it all down, you really shouldn’t underestimate the impact of liquidity (or lack thereof) on the marketplace. Whether you are talking about CLOs or individual corporate credits, the universe of market participants is relatively limited and lacks investment diversity, therefore, everybody is in the same trade. When you couple this to the fact that credit is a binary thing, you either get paid your interest and your principle back, or you don’t. So when you take this binary event, and place it all in the same hands, it doesn’t take a genius to figure out the consequences when risk is added to the equation. Both the loan and the CLO markets, have an Achilles heel, both become incredibly inefficient and illiquid when times are bad. But with inefficiency comes opportunity, and for those who are prepared, this Achilles heel presents a very exploitable opportunity. This is why I believe it makes sense for investors to maintain a permanent allocation to a value-oriented strategy in today’s corporate credit arena.