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Analysis
Opportunity in CLO double B tranches
by Oussama Nasr
Given their low default rates, double B CLO tranches offer much higher coupons than might be expected — suggesting they offer some of the best risk/return trade-offs in all of fixed income
To evaluate a credit arbitrage opportunity, we begin by evaluating an instrument’s excess annual spread over the risk-free rate paid by a treasury bond, taking into account the instrument’s annualised expected loss.
Assuming the investor is motivated solely by yield considerations, simple algebra shows that, very nearly, this arbitrage spread needs to satisfy the equation shown in figure a (below).
An example with corporate bonds
Consider a five-year USD-denominated triple A senior unsecured corporate bond. This bond has a historical credit spread over five-year US treasuries averaging around 75bps, and a lifetime default rate over the long term of 0.34%. Let’s assume its average recovery value has been close to 50%. Then we can calculate, using our formula, that the break-even spread is 3.4bps.
For our five-year bond, this spread would make the investor indifferent between buying this bond or a five-year US treasury because the 3.4bps annual yield advantage compensates for the 3.4bps annual loss expectation. Stated another way, if the investor bought a large, diversified pool of five-year bonds meeting the above criteria, she would earn, over the life of these bonds and net of expected defaults, the same yield as she would achieve by investing in five-year US treasury bonds (assuming the default and recovery experience of this pool of bonds replicates historical averages).
However, the bond actually pays 75bps over US treasuries. The remaining spread of 71.6bps is gravy, provided we ignore considerations unrelated to pure yield. In other words, this bond pays the investor an excess spread around 22 times the break-even spread.
CLO double B spreads 2020-25 (bps)
Source: Creditflux data
Plausible explanations for this type of credit arbitrage are numerous and include tax factors, complexity, and liquidity considerations. The tax-based argument centres on the preferential tax treatment of US treasuries under most US state tax laws. The liquidity argument asserts that US treasuries are always more liquid than risky alternatives and thus pay a lower yield. (We define ‘risky’ bonds as those having some probability of defaulting, however small.) And the complexity argument states that understanding a US treasury security is less time- and resource-intensive than understanding a risky bond, justifying once again a lower yield on the treasury security.
A similar credit arbitrage for corporate bonds is observed at every credit rating from triple A to triple C. The multiple of actual spread versus the break-even is not constant, declining from some 22 times for triple A credits to as little as twice only for triple Cs (see table, below).
The table lists for each broad credit rating the long-term historical five-year credit spread (over US treasuries), the long-term five-year default rate, the break-even spread derived from this default rate assuming a plausible loss-given-default of 50%, the excess spread actually paid by this bond over the break-even spread, and the multiple of that break-even that the total spread represents.
There is no objective basis for determining where and how an investor can best benefit from this credit arbitrage. If the absolute excess spread matters more, she should build her home in the B or triple C ratings categories, whereas if the multiple matters more, she should gravitate towards the triple A, double A and single A categories.
Factors that will likely influence her decision include regulatory considerations (such as Basel capital adequacy requirements if her institution is a commercial bank), performance measurement and attribution, compensation arrangements and more.
Credit arbitrage for CLO double Bs
Turning now to CLOs, we make a number of realistic assumptions:
- A five-year CLO double B tranche yields SOFR + 675bps (see chart, above).
- This tranche benefits from 8% par subordination, consisting of the B-rated junior tranche (if any) and the equity tranche, and represents 3% of the CLO’s total capital structure. We refer to this 3% as the tranche’s ‘thickness’.
- The loans purchased by the CLO consist uniformly of B-rated five-year senior secured leveraged loans yielding SOFR + 350bps, whose lifetime default probability is 16.37% (extracted from the table above), but whose recovery value in default can now be assumed to be 75% rather than only 50% on account of their excellent collateral package.
- The actual lifetime default rate of double B CLO tranches has been a mere 1.25%.
We note that the double B tranche’s expected recovery value is unlikely to be as high as that of the underlying leveraged loans. Given how thin it is, this tranche is wiped out fairly quickly once aggregate loan losses reach the level (8%) at which the tranche begins to write off principal, particularly if the maximum exposure per loan tolerated by the transaction is relatively high. Indeed, Moody’s reports that the average historical recovery of defaulted CLO double B tranches has been only 43%.
* The figure for triple A defaults over 5 years is higher than that for double As because of failures among triple A entities such as the monoline insurers and Icelandic banks during the GFC.
Source: Federal Reserve Bank of St. Louis
The CLO double B tranche delivers an excess of 460-510bps over its break-even spread
Applying our formula leads to a break-even spread for the double B tranche of 14.25bps, versus the 675bps or more it typically offers in reality. The excess spread is 660.75bps and the multiple is 47 times. Not only is the tranche’s risk/return tradeoff more attractive than for any corporate bond, it is also, in our opinion, more attractive than that of any other credit instrument in the fixed income markets generally.
We note that the 1.25% lifetime default rate for double B tranches is based on a total universe of 2,323 S&P-rated tranches, a figure substantial enough to give us comfort as to its sustainability over the long term. Indeed, S&P observes that a 7% annual default rate needs to occur on the underlying loans for the double B tranche to begin incurring losses. This default rate has been experienced only once in the past 25 years, and for a period that lasted less than two years (during the great financial crisis of 2008-09). This is far higher than the average 2% to 3% annual default rate experienced by this asset class.
Factors causing excess spread
It will be argued that a significant part of the double B tranche’s excess spread compensates the investor for the instrument’s illiquidity and complexity, and there is some truth to this. We observe, however, that CLO double B tranches are not that much more complex than CLO triple A tranches, which have been issued in recent years at spreads of only 150bps over Libor/SOFR (implying that the complexity premium is capped at this 150bps, and probably less).
The illiquidity argument merits attention. There have been meaningfully fewer double B tranches (2,323) than triple A tranches (5,085). Perhaps more importantly, the triple A tranche in any transaction is some 20 times larger than the double B tranche. Quantifying how much of the total spread this illiquidity premium represents is subjective, but it certainly reaches into the dozens of basis points.
Very unscientifically, we might break down the 675bps total spread into 100 for complexity and 50-100 for illiquidity, leaving the remaining 475-525 to compensate very generously for the instrument’s expected loss. Even at this revised figure, the CLO double B tranche delivers an excess of 460-510bps over its break-even spread and a multiple of 33 to 37, still more than any corporate bond appearing in the table, except for triple Cs.
Whither efficient markets?
Why is the market not more cognisant of this hidden goldmine? Why hasn’t it poured funds into it until its excess spread aligns more snugly with that of competing alternatives? Undoubtedly, there continues to be an important segment of the investor community that remembers the horror stories of synthetic CDOs marketed just before the GFC, and that chooses to ignore the key differences in structure and performance history between them and CLOs.
More significantly, we should ask why CLO triple A tranches pay such a generous spread (150 over the long term) when they have experienced zero defaults in their 30-year history. Relatedly, we wonder why B-rated broadly-syndicated leveraged loans continue to offer 350bps over SOFR when their break-even spread can be shown to be only 82bps?
Only a sorcerer with a crystal ball could predict which of these three instruments will be first to reprice at more rational spreads.
