March 6 (LPC) - A number of fast money accounts that participate in the U.S. collateralized loan obligation market are trading out of lower-rated CLO tranches and into senior tranches in the secondary market, setting the stage for further tightening at the top of the CLO capital stack.
Hedge funds, the main buyers of so-called BB CLO paper- a mezzanine tranche that sits just above the B and equity tranches in a CLO’s capital structure- are now retreating from that trade as they expect little wiggle room left in the recent BB rally, which has been facilitated by a risk-on environment so far this year.
Between mid-September, when the capital markets were struck by heightened macroeconomic volatility, and March 1, the average bid for the BB tranche has risen from 60 cents on the dollar to 67 cents on the dollar in the secondary CLO market, according to data from Morgan Stanley.
“Smart money accounts are taking profits from the BB tranches they bought in the past few months and moving that money into the AAA,” said a source who trades CLOs.
Due to growing demand over the past six months, the average secondary spread on the BB tranche has tightened from nearly 1300 basis points to 1000 basis points, according to data from Citi.
Meanwhile, the senior-most parts of the CLO capital structure, namely the AAA, AA and A tranches, and the lower-most piece, the equity tranche, remain well bid in the secondary market.
The average bid for AAA paper in the secondary market has risen comfortably from 91.25 cents on the dollar to 93.88 in the past six months, according to Morgan Stanley. Price appreciation has been even greater in the AA and A tranches, with the average bid in them spiking five points to 84 cents on the dollar and eight points to 77.50 cents on the dollar, respectively, between September and early March. The average bid in the equity tranche in the secondary market has shot up nearly 10 points to 85 cents on the dollar.
Primary more attractive than secondary
Many market participants suggest that given the consistent run-up in secondary prices, the primary CLO market, with its cleaner collateral and lower leverage, offers better value to investors. Among other things, in new deals, investors exert more control.
“If you buy equity in the secondary, you frequently have to be a minority investor, which means that the majority investor can decide when to call the deal and end your income stream,” said the CLO trader. “In the primary, you are the majority investor.”
The primary market has witnessed a flurry of new issuance as funds seek to take advantage of a low-volatility environment, which makes it easier for CLO issuers to price their liabilities in tandem with the underlying leveraged loan assets.
So far this year, nearly $4 billion in CLOs have priced in the primary market, and many of them are repeat issuers from last year.
“CLO liabilities are still too wide on new issue deals compared to the vintage deals of 2006,” said a CLO manager. “It’s the best bargain right now for buyers.”
But he cautioned that CLO liabilities spreads- which have declined in the last month from 155bp to 145-150bp on the AAA tranches of recently priced primary deals- need to continue to tighten for the healthy momentum in the CLO market to continue. “If the asset side doesn’t reverse, and it isn’t looking like loan spreads are going to widen instead of tighten, then CLO liabilities have to come in to make the spread arbitrage enticing for people to issue CLOs.”
The main reason that newly priced AAAs have not yet tightened to the 100bp area, which many believe is where they should be printing, is a continued absence of a depth of demand for the CLO product, sources said.
Despite renewed demand over the past year from foreign and U.S. regional banks and insurance companies, the AAA market is missing a wide pool of investors that could beef up buying. But absent any broader market volatility, demand for the AAA tranche in new issue deals should remain strong, leading to continued spread tightening, sources said.
Smita Madhur is a senior writer at Thomson Reuters Loan Pricing Corp in New York