Monday, August 17, 2009

CLO tranches follow the leveraged loan rally

The recent rally in leveraged loans is making it's way into the secondary CLO market. In the dark days of late 08 - early 09, secondary CLOs got hit from several sides. On one hand the natural buyers for senior paper have all but disappeared due to the collapse of the ABCP markets. On the other hand concerns about the collateral quality continued as leveraged loan default rates escalated rapidly. The junior tranches were trading cents on the dollar as participants anticipated cash flows being cutoff from due to expectations that deals will hit their OC triggers (see Moody's pounding CLOs with downgrades ).

There were a few buyers of AAA CLO tranches who felt that AAA CLO paper has what's called "positive convexity". If credit deteriorates, OC triggers get hit and AAA starts getting paid down. Even though collateral gets worse, the principal is getting reduced. And unlike other types of CDOs, the cushion for AAA in CLOs has generally been sufficient - so far. If credit does not deteriorate enough to hit OC triggers, the principal would not get reduced, but spreads will tighten. A few saw this positive convexity as an opportunity to get long secondary AAA CLOs (the primary market is virtually shut down) and at 60-70 cents on the dollar some took a chance. Anything below AAA was viewed as highly speculative and traded at massive discounts.

How the times have changed. As the collateral rallied (see Leveraged loan rally continues), the securitized product is starting to rally as well. The projected collateral default rates have dropped in part due to all the amend-and-extend activity. There is clearly an arbitrage opportunity when the senior most tranche of a loan portfolio is yielding more than the portfolio itself. The AAA rally in turn is pulling with it the lower tranches.

From Wells Fargo:
CLO bull market is raging on. After a big rally in May and June many customers expected a pullback in July, and while we had a couple of weeks of summer lull, the last four weeks prices trended straight up, aided by low supply. A lot of activity was on top of cap structure, with most 1st pay AAA improving from high 70s to mid 80s and AAs from low 50s to mid 60s.


What lies ahead? CLOs are STILL cheap to loans and HY, fundamentals are clearly improving, there's negative net supply of paper, and rating agencies haven't gone overboard with downgrades. Unless there is a meaningful pullback in credit and stocks (SP500 back to 900), we don't see much weakness coming up.

It's certainly impressive to see a rally in a structured credit market, given the dirth of natural buyers. However with the recent equity markets' correction, it may be time for this market to take a pause.

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