The chart
Until the late-2022 market turmoil, BBB rated European CLOs traded at similar spread levels to traditional high-yield corporate bonds. Despite the year-to-date rally, the gap of recent years remains wide.
Source: Ninety One, Citi, JP Morgan, ICE. As of 14 May 2024. European high-yield spreads are swap option adjusted spreads (OAS) from the ICE index HE00. European CLO spreads are discount margins tracked by Citi.
The context
The European market for collateralised loan obligations (CLOs) – securities that package up a portfolio of corporate loans into ‘tranches’ of different risk levels – was a casualty of the crisis sparked by the infamous UK “mini-budget” in late 2022. Things have improved a lot since then and a recent tightening of credit spreads on European CLOs has helped the market deliver healthy year-to-date total returns (6.6% in the BBB rated segment – more than three-times the total return of the European high-yield bond market)1.
The drivers of this are varied: CLOs pay a floating rate coupon, allowing them to benefit from the rise in interest rates this year; strong appetite for credit risk has also provided a boost; and some factors specific to the CLO market – such as deleveraging dynamics – have also pushed down spreads, as we discussed in a previous Picture This.
Despite these favourable year-to-date moves, CLO debt tranches continue to offer an attractive spread pick-up relative to traditional high-yield corporate bonds. As the chart shows, BBB rated European CLOs have historically tracked the European high-yield corporate bond index fairly closely, but the gap of recent years remains wide.
The conclusion
We think parts of the European CLO market are yet to fully recover from the market stress prompted by the UK mini-budget and subsequent liability driven investment (LDI) crisis in late 2022. This leaves further room for spreads to normalise relative to comparable products such as high-yield corporate bonds, making a relatively compelling investment case for areas such as the BBB rated segment of the market.
However, an increasingly selective approach is necessary. CLO returns are sensitive to the performance of the underlying loans, and as we discussed in a previous Picture This, dispersion is rising in the leveraged loan market. Picking the right combinations of CLO manager, loan portfolio and deal structure is of paramount importance.
1 Euro CLO returns are from JP Morgan's Euro CLOIE index.
