Treading Carefully: Risk and Opportunity in CLOs and Bank Loans
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.
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From a performance standpoint, lower-quality loans have significantly underperformed higher-quality loans this year, as Figure 2 illustrates.
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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.