A reincarnated version of collateralized debt obligations, backed by both high-yield bonds and leveraged loans, offers investors some of the best relative-value plays in fixed-income, according to Credit Suisse Asset Management.
So-called hybrid CDOs may be “the cheapest thing in the entire globe with a AAA rating,” Amir Vardi, a structured products portfolio manager at the firm, said Tuesday while speaking on a panel at Information Management Network’s annual Investors’ Conference on CLOs and Leveraged Loans.
Market participants say today’s CDOs bear little resemblance to the ones that contributed to the financial crisis. They argue that corporate debt is far less risky than the subprime mortgages and credit derivatives that ended up in the securities a decade ago.
CDOs being issued now are also largely investment-grade, structured with plenty of credit protection, have far less leverage than pre-crisis corporate CDOs, and pay a fixed-rate coupon, unlike collateralized loan obligations.
Moreover, issuers say that they can adjust asset mixes -- toggling from loans to bonds, or vice versa -- during the life of a deal to profit from interest-rate gyrations while keeping liability costs fixed.
“You can’t find anything that compares” in terms of relative-value, Vardi said to a standing-room only crowd at the Sheraton Times Square Hotel. “Not many people look at them,” he added, noting that tranches from “AAA down to BBB” look cheap.
The market for these CDOs remains small, with about $10 billion sold since 2015. Anchorage Capital Group, Palmer Square Capital Management and Brigade Capital Management are among the most recent issuers. Blackstone Group’s credit hedge fund priced a deal last November.
AAA tranches pay coupons in the range of 4.4% to 4.8%, according to data compiled by Bloomberg, versus about 2.42% for 10-year U.S. Treasuries. Vardi also sees value in the BBB tranches, which could pay between 5.5% and 7%. He conceded that investors give up some liquidity with hybrid CDOs.
“Of course, you’re securitizing some unsecured bonds and some second-lien loans and CCC loans, but you get comfortable with that,” he said. “There’s a lot of value in that part of the capital stack, too.”
Some investors worry that the flexibility to add bonds means that an issuer can theoretically transition the CDO to a structure 100% backed by high-yield corporate bonds, perhaps coinciding with the next economic downturn.
The higher amount of junk-rated bonds means the assets have lower recovery rates than deals backed mostly by leveraged loans. Moreover, Moody’s Investors Service says that up to 17.5% of the assets in these structures can be comprised of Caa rated assets, whereas a typical CLO has a purchase limit of only 7.5%.
Other panelists -- including Justin Pauley, a senior structured credit analyst at Brigade Capital Management -- agreed that hybrid CDOs offer some of the best relative value at the AAA level. Still others, including Gretchen Lam, a senior portfolio manager at Octagon Credit Investors, noted that the overarching collateralized loan obligation market has been cheap across the board this year versus the rest of fixed-income.
The $600 billion CLO market, backed by broadly syndicated leveraged loans, was one of the few asset classes that largely resisted spread tightening this year. Spreads are widely expected to tighten gradually over the rest of 2019.
“CLO AAAs are really interesting on a relative basis, and the entire stack is cheap right now, with the possible exception of BBBs,” Lam said. “Cheaper loans, higher overall spreads, and a limited ability for the loan market to reprice those loans over the next three months” makes CLOs look like a bargain right now.
