CLO, Asset-Backed buyers Fear Rally Doesn’t Match Fundamentals

(Bloomberg) -- The sharp rally in securitized products that’s been driven by investors seeking to escape low and negative yields may mask a grimmer reality, investors warn.

While debt tied to U.S. leveraged loans to businesses and consumer products and even commercial mortgages has rallied hard from March lows, recent pricing trends may not reflect the headwinds some sectors face. Investors worry about so-called tail risk, or the possibility that some event down the line will eat into expected returns.

“There’s definitely a disconnect,” Tracy Chen, head of structured credit at Brandywine Global Investment Management, said in an interview. “In the real economy there is still pain, and people are out of jobs. It’s very, very bleak. But yet you see spreads tightening to the point that there is difficulty in sourcing bonds. Investors realize there are not enough sectors with value that you can find now.”

Read more: Aircraft-lease bonds draw high demand as investors seek yield

The rebound in securitized debt, which lagged some other sectors initially last year, accelerated further when news of viable vaccines broke. Now risk premiums in some sectors are even narrower than they were before the pandemic.

Taking Chances

With benchmark rates lower for longer, a desperate search for yield to find any hint of value is causing some investors to mine lower-rated bonds, with few options left for price gains. Good risk-reward is more difficult than ever to find, Chen said, and money managers are putting faith in credit enhancement and other structural safeguards designed to protect investors.

Spreads have tightened so much, for instance, that only CLO BB tranches and equity are still attractive versus corporate bonds from a relative-value standpoint, along with CMBS single-As and BBBs, Chen said. These are the only bonds that haven’t yet retraced all of their value. Chen said she prefers to stick to relatively conservative portfolios in higher rating tiers.

ABS not only retraced their Covid spread widening, but narrowed beyond pre-Covid levels at some senior rating tiers. CLO AAA liabilities, meanwhile, have tightened to pre-Covid levels for top-tier issuers, setting off what may be a record-breaking year for refinancings and resets as managers jump on the chance to sweeten deal terms for existing transactions.

Areas of particular cause for concern may be the long-term fundamental health of the leveraged loan market, which is seeing a significant rally and experiencing the lowest yields since 2018, and the health of the consumer, which feeds into areas such as subprime mortgages, experts say.

The additional government stimulus helps. “But the consumer will need weaning off at some point,” said Justin Gregory, partner and portfolio manager at Hildene Capital Management. “There will be a handoff to a higher unemployment environment with a fundamentally weaker economy. What’s that going to look like?”

The ending of the stimulus isn’t the only question mark. For commercial real estate, with a vast swath of borrowers in forbearance plans, it’s impossible to tell what the ultimate outcome will be, investors say. There’s too much uncertainty regarding to what extent sectors such as hospitality and retail will recover once more people are vaccinated and can leave their homes more freely.

“The vaccine is a truth serum,” said Michelle Russell-Dowe, head of securitized credit at Schroders. “Once the population is vaccinated we will see what’s mirage and what’s reality in several sectors.”

Relative Value: CMBS

• Bank of America Corp. analysts remain neutral on last-cash-flow AAA conduit CMBS spreads, and think the best potential near-term conduit market relative value exists further down the capital stack among new-issue transactions, according to a recent report
• They recommend an overweight on single-A and BBB- rated conduit paper, as well as on SASB hotel and retail deals, Freddie K “C” classes, and agency credit risk transfer deals

Quotable

“Private mortgage lending will come back again; I expect a reasonable amount of non-conforming jumbo-mortgage securitizations this year,” said Bryan Filkey, chief strategy officer at Interfirst Mortgage Company, a Chicago-based originator. “As far as Non-QM loans, however, credit rating agencies are fairly draconian around alternative documentation. They’re still tuning their models for Non-QM. Their credit enhancement levels don’t make any sense for that sector anymore. Issuers can now just do some of those deals as non-conforming jumbo transactions.”

What’s Next

ABS deals in the queue for next week include Crossroads (small to mid-ticket equipment), Triton (container lease), Foursight Capital (near-prime auto), Exeter (subprime auto), and First National Holdings (tax-lien ABS). A subprime auto ABS from Consumer Portfolio Services may price on Friday.

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