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Opinion CLOs
CLO double Bs have returned 40.1% — nearly double high yield bond returns
by Thomas Majewski
Thomas Majewski
Founder & managing partner
Eagle Point Credit Management
In a declining rate environment, CLO debt can still deliver strong performance
As the Federal Reserve pivots toward monetary easing with a cut of 50 basis points, we continue to see support for a ‘no landing’ scenario as the economy settles back into normal conditions following the post-Covid period of high inflation.
Last month in this column, we highlighted that CLO equity is fundamentally a spread arbitrage play and will likely see minimal impact on returns from rate cuts. This month, we’re unpacking what lower rates could mean for CLO debt, and why we believe investors are still better off investing in CLO debt than in high yield bonds, despite a declining rate environment.
Semper paratus (Latin for ‘always ready’) is the official motto of the United States Coast Guard. We also think it could be a relevant slogan for CLO double Bs. Despite their floating-rate structure, we believe they continue to offer superior absolute and risk-adjusted returns compared to traditional fixed rate high yield bonds. CLO double Bs enjoy a premium spread and meaningful structural protections, which have helped keep historic losses for CLO double Bs close to 0% over the past 20 years. Despite the higher spreads and lower defaults, they continue to be under-appreciated by many credit investors. Therein lies opportunity.
Premium spreads and a double cushion
The main drivers of the outperformance of CLO double Bs versus high yield bonds in a moderately declining rate environment are their premium spreads and the benefit of two layers of equity subordination (the equity in the underlying companies and the equity in the CLOs).
As of early September, CLO triple/double B spreads were on average 370/693, while comparable high yield spreads were 273/405 at the double B and B levels. This shows a premium spread return for an investment roughly an entire ratings category higher. Furthermore, even the most astute credit picker will end up with a few troubled names in a diverse pool of high yield bonds. Looking at high yield bonds without taking a haircut for the inevitable idiosyncratic name-specific losses is a fool’s decision. Those same idiosyncratic losses in a CLO are first absorbed by the equity class of the CLO, not the CLO double Bs.
Over the past year, we have continued to see high yield spreads compress, while CLO triple/double B spreads have remained in historical ranges. Despite this, from January 2023 to August 2024, CLO double Bs have returned 40.1% — nearly double the 20.6% total return of high yield bonds. While high yield bonds have the potential for further rate-based appreciation, the appreciation is limited by the maturities on bonds and their typically shorter non-call periods. By contrast, CLO double Bs typically only lose yield when rates fall, and they usually don’t drop in value in declining rate environments due to their 0.25-year rate duration.
Near zero defaults for two decades
Over the past two decades, due to their robust structural protections, CLO double Bs have demonstrated near-zero default rates. Indeed, over the past 20 years, they’ve had less than 5bps of defaults per annum. This compares extremely favourably to the approximately 300bps of annual defaults for high yield bonds over the same timeframe. Even if high yield bond default rates remain below their long-term average, it is hard to pick a diverse portfolio of name-specific credits and not make a few mistakes. This contrast in credit performance, coupled with yields that have consistently outpaced high yield bonds by 250-350bps, makes a compelling case for CLO double Bs in any rate environment.
Furthermore, as interest rates decline, loan borrowers within CLOs benefit from reduced interest expense, potentially boosting cashflows. The improvement in fundamentals can lead to potentially lower defaults as the interest burden is eased, as well as higher valuations for leveraged companies, which positively impacts the market value of CLO collateral. This benefit doesn’t apply to high yield bond borrowers, which have fixed interest costs.
As we navigate the pivot in monetary policy, the case for CLO debt versus high yield bonds remains strong. While the absolute yield on CLO double Bs may decline slightly with falling rates, their relative value proposition versus high yield bonds remains intact. We believe the combination of structural protections and premium spread will enable CLO double Bs to continue generating total returns comfortably in excess of high yield bonds.