Portfolio Strategy

December 13, 2019

The Big Idea

Challenges in credit, shifts in managers, new MM appeal

Steven Abrahams, Jinzhao Wang | December 13, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Borrowers and managers relying on a benign market for credit are likely to face challenges next year. A steady but slow economy and wider spreads in ‘B3/B-‘ broadly syndicated loans should put the weakest business models at risk across market sectors and require CLO managers to navigate choppier credit. Manager performance will likely require strong credit teams and better-than-average liquidity. And the generally stronger credit in middle market loans may look good by comparison.

Testing the most leveraged credits

Some of the weakest credits in the lending market, the ‘B3/B-‘ loans making up nearly 20% of the outstanding market, should come under pressure from at least two directions next year and help steepen the CLO spread curve from ‘AAA’ down to equity. First, US growth should run slightly below 2%, good compared to the rest of the world but likely still well below the pace needed for loans underwritten to earnings expectations in mid-2018 when real GDP was running at 3.2%. The lower growth should translate into revenue shortfalls for the weakest business models across market segments and speed up repricing and migration to lower ratings. Widening spreads on ‘B3/B-‘ loans this year should add to the pressure. Borrowers with approaching maturities or trying to extend their debt stand to face much wider spreads than their current loans’. For loans originated before mid-2018, current LIBOR and wider spreads could mean higher absolute rates. Unless the borrower finds some way to deleverage, ratios of earnings-to-interest-expense should come under pressure. Low prices on ‘B3/B-‘ loans that get downgraded to ‘CCC’ could also lead some issuers to buy back some or all of their debt, triggering a rating agency downgrade of the issue. Volatility in loan spreads and ratings should add a risk premium to the CLO equity and lower rated debt most sensitive to portfolio market value. Migration up in the capital structure by some investors along with inflows from investors looking for yield should tighten senior debt spreads. The CLO spread curve should steepen.

Reshuffling of CLO manager performance

Volatility in leveraged loan credit next year looks set to keep reshuffling CLO manager performance, opening up sizable gaps in value across CLO equity and lower-rated debt. Some managers with longstanding reputations for good performance fell hard in 2019 while others managed to keep their records intact. The correlation between managers’ excess returns on their leveraged loan portfolios for the 12 months ending in November 2018 and for the 12 months ending November 2019 was low (Exhibit 1). Managers with the most reliable 12-month performance from November 2018 to November 2019, at least measured by excess return over the broad loan market, generally had broad and deep teams of analysts often with some roots in distressed investing.  Managers with less reliable records tended to come from shops with fewer resources. The loan market next year will likely keep challenging managers with a heavy supply of ‘B3/B-‘ loans, ratings migration and price volatility. It looks unlikely that managers will be able to avoid the challenges by moving up into the limited supply of better credits. Managers will likely need strong credit staffs, broad diversification and reasonable liquidity to have a chance to do well. Investors should also look for deals with relatively low price sensitivity to the broader loan market since those portfolios will tend to have more stable MVOC. Opportunity for relative value trading across managers should be robust with the biggest distinctions coming in equity and speculative-grade CLO debt.

Exhibit 1: Managers’ good portfolio alpha in ‘18 did not predict good alpha in ’19

Note: for more detail on calculation of CLO manager performance and excess return, see ‘CLO managers ride a loan roller coaster into November,’ APS Portfolio Strategy, December 9, 2019. Source: Amherst Pierpont Securities

The increasing appeal of middle market CLOs

The attention to credit next year in CLOs backed by broadly syndicated loans should unintentionally reflect well on CLOs backed by middle market loans. The better middle market CLO managers still tend to originate their own paper, get ample covenants and actively use them to monitor and, if need be, restructure the debt. Tight control should keep expected recoveries strong, including the ability to restructure a weakening loan into a higher coupon and tighter covenants and sell it for par. But careful review of the manager, its portfolio track record, typical covenants and loss mitigation strategies is important.

Wider spreads for the same rating in middle market CLO debt reflect, among other things, both the lack of transparency on the loans and the lower liquidity of the debt. Transparency and liquidity differences could narrow next year if volatility in ‘B3/B-‘ debt materializes. Better credit in the collateral backing middle market CLOs from the best managers should make the spread difference attractive.

The underlying consensus

Other aspects of the CLO market seem widely anticipated. Expectations for new issue volume range between $75 billion and $90 billion. Investment in CLO equity is expected to continue moving away from hedge funds and toward managers and outstanding risk-retention vehicles. Demand for CLO debt from money managers, pension funds and other total return portfolios is likely to increase.

Steven Abrahams

1 (646) 776-7864

sabrahams@apsec.com

Jinzhao Wang

This material is intended only for institutional investors and does not carry all of the independence and disclosure standards of retail debt research reports. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of Amherst Pierpont’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, Amherst Pierpont may act as a market maker or principal dealer, and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.

This message, including any attachments or links contained herein, is subject to important disclaimers, conditions, and disclosures regarding Electronic Communications, which you can find at https://apsec.com/disclaimers.

Important Disclaimers

Copyright ©2022 Amherst Pierpont Securities LLC and its affiliates (“Amherst Pierpont”). All rights reserved. Amherst Pierpont Securities LLC is a member of FINRA and SIPC. This material is intended for limited distribution to institutions only and is not publicly available. Any unauthorized use or disclosure is prohibited.

In making this material available, Amherst Pierpont (i) is not providing any advice to the recipient, including, without limitation, any advice as to investment, legal, accounting, tax and financial matters, (ii) is not acting as an advisor or fiduciary in respect of the recipient, (iii) is not making any predictions or projections and (iv) intends that any recipient to which Amherst Pierpont has provided this material is an “institutional investor” (as defined under applicable law and regulation, including FINRA Rule 4512 and that this material will not be disseminated, in whole or part, to any third party by the recipient.

The author of this material is an economist, desk strategist or trader. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of Amherst Pierpont’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, Amherst Pierpont or any of its affiliates may act as a market maker or principal dealer, and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.

This material (i) has been prepared for information purposes only and does not constitute a solicitation or an offer to buy or sell any securities, related investments or other financial instruments, (ii) is neither research, a “research report” as commonly understood under the securities laws and regulations promulgated thereunder nor the product of a research department, (iii) or parts thereof may have been obtained from various sources, the reliability of which has not been verified and cannot be guaranteed by Amherst Pierpont, (iv) should not be reproduced or disclosed to any other person, without Amherst Pierpont’s prior consent and (v) is not intended for distribution in any jurisdiction in which its distribution would be prohibited.

In connection with this material, Amherst Pierpont (i) makes no representation or warranties as to the appropriateness or reliance for use in any transaction or as to the permissibility or legality of any financial instrument in any jurisdiction, (ii) believes the information in this material to be reliable, has not independently verified such information and makes no representation, express or implied, with regard to the accuracy or completeness of such information, (iii) accepts no responsibility or liability as to any reliance placed, or investment decision made, on the basis of such information by the recipient and (iv) does not undertake, and disclaims any duty to undertake, to update or to revise the information contained in this material.

Unless otherwise stated, the views, opinions, forecasts, valuations, or estimates contained in this material are those solely of the author, as of the date of publication of this material, and are subject to change without notice. The recipient of this material should make an independent evaluation of this information and make such other investigations as the recipient considers necessary (including obtaining independent financial advice), before transacting in any financial market or instrument discussed in or related to this material.