CLO bottom rung cheapens due to downgrades

As the collateralized loan obligation (CLO) market seizes up, bargains are plentiful, according to wary traders. In 2016, the energy sector collapsed for a short time but decimated the leverage loan market as clean BBs CLO tranches dropped to 50 cents on the dollar. But fears of CLOs paying-in-kind (PIK) didn't materialize, and investors were ultimately paid. "Why is it that CLO BBs expected to PIK, without any ambiguity, have been traded in the 50s in April?" said one hedge fund CLO trader. "What's different today versus 2016 to inspire CLO investors to price greater risk at higher prices? Fed optimism?” BWIC data is helpful for tracking CLO senior bonds, however, equity to single-Bs are often not captured because they are executed through private sales. Plus, large block de-risking sales from mutual funds are traded privately. PGIM sold $2 billion of CLO AAA sale in March to Citi due to a mutual fund daily redemption requirement. A handful of large institutions, in addition to PGIM, were forced to sell giant blocks of AAA CLOs in March, which were all sold privately. Citigroup reportedly reaped more than $100 million from the PGIM sale. Last week secondary CLO 2.0 flows dropped to $791 million (30% did not trade), from $1.06 billion the prior week, according to BWIC data provider Empirasign. CLO AAA to A classes tightened 10 basis points (bps). However, CLO BBB and BB spreads widened 25bps and 50bps, respectively due to downgrades, Bank of America analysts wrote. On the other hand, trading sources report severe impairment to lower mezzanine CLOs that BWICs fail to illuminate. We know for certain that the Fed rally that lifted CLO 2.0 mezzanine bonds, such as BBs up 7-10%, is over for now. Multiple traders confirmed the following CLO levels, with lower BBB to equity ranging as much as 10% depending on downgrades. One single-B was recently seen trading at a 2500 spread. U.S. CLO 2.0 Trading Levels (bps/$)* * according to market sources A look at the technicals Investors who thought CLO upper mezzanine, such as A/BBB would never stop cashflowing, are in for a terrible surprise. Twelve CLOs have failed AA/AAA over-collateralization (OC) tests so far. "For investors who like CLO BBs in the 45 area, there's as much as they want to buy available on BWICs," said one trader. "However, we believe the COVID impacted economy has made BB CLO offers even in the 20s expensive." Adding that: "We are looking for Great Depression proof bonds, such as non-PIK-able CLO AAAs at 80-85 cents." AAAs have been seen trading at a 97-cent discount. Some of the larger managers have had 50% or more of their deals breach at least one test in April reports. Bank of America estimates management sub-fees of around $35 million have been deferred as a result of the OC test breaches. The deferred fees could be recouped by managers once the tests cure, however.

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