Monday, February 4, 2013

AAA CLO paper looks attractive on a relative basis

In the post-financial-crisis environment, securitization markets are limited to a handful of products that continue to trade. Basically the active markets are made up of GSEs' sponsored MBS (agency MBS is by far the largest structured credit market, with the Fed as the largest buyer), ABS pools (these include autos, credit cards, and student loans), and CLOs. All are quite critical for the US economy, as bank credit is replaced by these forms of "shadow banking".

In the "AAA" universe, CLOs (securitized corporate loans) continue to be the most attractive on a relative basis. The spreads for credit card and auto ABS for example are now a fraction of the CLO spreads.

SL="student loans", CC="credit cards" (source: JPMorgan)

With little room for further compression in the ABS space, the CLO market becomes interesting for investors. It's the only "AAA" paying around LIBOR+120bp, as the market prices in the risk of the rating agencies getting it wrong once again. Clearly the market that used to include bank-sponsored commercial paper vehicles has shrunk, reducing the number of "natural" buyers of this paper. Regulatory changes make it less palatable for banks to hold it. Hedge funds also have a tough time with AAA paper because the yield is too low for their target returns, while obtaining leverage for such bonds is quite difficult (hedge funds tend to focus on lower rated CLO tranches). That leaves insurance firms who have been a bit gun-shy due to their CDO fiasco in 08. Many are also less comfortable with longer maturities of CLO bonds vs. 3-year or shorter ABS. But with demand for floating rate product picking up (see discussion), the CLO market should do quite well in 2013, as yield-hungry investors turn to this market for an extra 100bp of spread.

For those interested in learning more about CLOs, here is a good, although somewhat dated paper from Babson (one of the largest CLO managers).
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