EIC - JBBB And CLOZ: Safer Higher-Rated CLO Debt Paying In The Double-Digits

2023-04-04 17:11:39 ET

Summary

• As Baron Rothschild once said: "Invest when there's blood in the streets".
• The credit markets seem to have some blood in them too, and we are seeing continuing bargains in high yield corporate credit.
• Especially CLOs, where the safe, mid-level debt tranches, well-protected from the likelihood of defaults and losses, are paying in the double-digits.
• That's why we're seeing new ETFs being launched to buy these tranches, with heavy investor participation by large institutions.

[This article was first published for Inside the Income Factory® subscribers on March 17th ___________________________________________________

"Invest When There's Blood In The Streets" - Baron Rothschild

Yesterday I saw a news item about a new collateralized loan obligation ("CLO") being sponsored by Golub Capital Partners and distributed by Bank of America. Here was the initial pricing.

Just to help everyone interpret this, let's review what this means:

• The size and structure of the CLO. Note the CLO is raising all the money listed in the second column, i.e. 248 + 8 + 42.8 +24.4 + 24.8 + 14 + 38.5 = $400.5 million
• That money, after paying start-up expenses, is used to purchase senior, secured, floating-rate corporate loans
• When you stack up all those classes of debt, you have the liability side of the CLO's balance sheet, with each class above the other in priority of payment. That means when the CLO reaches its redemption period, perhaps 8-10 years out, and its loan assets mature and repay, or are sold in the secondary market, the proceeds will be used to pay off the top debt tranche first, then the next tranche down, etc.

As we've described previously ( here and also here, as well as in my book where there is a chapter devoted to CLOs), it would actually be hard to lose money in the top and middle tranches of a CLO.

Here is why. Look at the top-4 tranches of the above CLO, which have ratings ranging from triple-A down through single-A. Together those tranches account for 248+8+42.8+24.4, or a total of $323 million, of the combined $400 million in liabilities and equity of the CLO. That means you have $400 minus $323, or $77 million, of junior liabilities and equity (the tranche labeled "subordinate" is the equity) underneath those top-4 tranches serving as a cushion to absorb losses before the next highest tranche, the one labeled "Class C" and rated single-A, would suffer a loss. Let's also assume that as much as $5 million of the equity might have been spent on legal and investment banking fees, and other expenses (I hope it's not that much, but we'll be conservative) in launching the CLO, bringing the actual junior liability and equity cushion down to only $72 million, and leaving $395 million to be invested in corporate loans.

Now let's compute the amount of losses our CLO's loan portfolio would have to suffer in order to eat through a $72 million cushion. $72 million as a percentage of the $395 million loan portfolio would be 72/395, or 18%. So we'd need losses of 18% to wipe out the equity and the BB and BBB-rated debt. Since the loans are all senior and secured, it means that when one of them defaults, the lenders typically recover 60-70% of the loan principal, based on comprehensive default and recovery statistics going back many decades. But just to be conservative, we will assume that the recoveries are only 50%, which would be very low and actually more like unsecured high yield bonds typically recover rather than what better-protected, secured loans collect.

But even assuming a low 50% recovery rate, that means that in order to lose 18% of a portfolio, you'd have to start with defaults of twice that rate, or 36%. That would require an economic and financial cataclysm beyond any of our experience or imaginations. In the "great recession" of 2008, the corporate default rate got to about the 10% rate, and even during the worst three-year period during the "great depression" of the 1930s the default rate only totaled 12.8% . So corporate defaults would have to be about three times as great as those during the great depression in order for even the lowest of the top four debt tranches to be at risk from credit losses. That means, of course, that the top tranches, the triple-A and double-A, are even better protected.

But what of the triple-B-minus and double-B-minus tranches? The triple-B tranche pays a whopping SOFR + 550 basis points, or about 10% in all, an amazing yield for what is still an investment grade credit. It has a cushion of $47 million under it, which is the BB- tranche of $14 million and the subordinate/equity tranche of $38.50, minus the $5 million of set-up expenses. A loss of $47 million on a loan portfolio of $395 million would also require an unusually incompetent lending performance.

$47 million divided by 395 = 12%. Assuming again a very low recovery rate of only 50%, that would mean you'd need a default rate of 24% to burn through your cushion. And if you assumed a more realistic recovery rate of 60%, which is still below the historical average, you would need a default rate of 30%, or almost three times the default rate of the great recession, to eat up your cushion and touch the triple-B tranche.

That degree of safety is why so many institutional investors have been buying the middle tranches of CLOs, for quite some time and probably even more in the current climate where rates have risen so much. It also explains the launch of so many new ETFs designed to buy CLO debt. Two that I like and have mentioned recently, and also have been nibbling at for my own portfolio, are Janus Henderson B-BBB CLO ETF ( JBBB ), currently yielding about 7%, but with potential for more if debt markets continue to provide "worry discounts" to investors (also 77% institutional ownership); and Panagram BBB-B CLO ETF ( CLOZ ), started more recently and still building out its portfolio.

Finally, the debt tranche called "Class E" on the chart and rated BB-. This has nothing below it but the equity to protect it from loss, but the history of CLO BB-rated tranches over the past 30 years or so since CLO's got started has been excellent, with hardly any losses and a well-documented overall default and loss record better than that of ordinary garden-variety corporate debt rated double-B.

With only the equity beneath it the double-B tranche would have a cushion of only about $33 million. Since 33/395 = 8%, that means a default rate of double that, or 16% would be required for losses to touch it. Or more realistically, assuming a 60% recovery rate, a default rate of 20%. That means double-B tranche holders of CLOs are safe unless we get very serious recession-level defaults at a rate about one-and a half to twice as serious as in the 2008 crash.

While that's not the fortress-like protection we see above it in the CLO liability pyramid, it's still pretty solid for what we'd be paid in today's market. Notice that in this particular CLO, the BB- rated tranche is not priced, but is merely marked "retained." That's because the sponsors of the CLO feel they'd have to price it so high (like about 14% I'm hearing from friends in the market) that they might as well keep it, or sell it later to investors with more of an equity risk/reward appetite. (By the way, Eagle Point Income ( EIC ) one of our favorite funds and holdings, specializes in BB- rated CLO debt, with about 70% of its holdings in it; the rest in CLO equity. It's got a different, more aggressive risk/reward profile than JBBB and CLOZ. If I weren't full up on it, I'd probably be picking up some more as well.)

I wanted to get this article out quickly. I hope it's useful insight.

Good luck everyone!

Steve

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