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The hunt for yield has supported market expansion

The LL market expanded 2.2x to USD1.1tn in the decade to February 2020, driven mainly by the hunt for higher yield and ample market liquidity. Seventy percent of issued LLs were held by rule-based CLO managers. Lower yields on traditional assets resulted in AMs shifting their focus to alternative investments such as LLs and CLOs that offered more attractive yields.

Slowing economic cycle: Cracks appearing in the LL and CLO markets

Concentration risk in CLOs arises from the following:

Acuity Knowledge Partners’ unique experience

The economic slowdown triggered by the COVID-19 pandemic has exposed this fragility in the credit markets, which has witnessed widening spreads and low liquidity since March 2020 (the S&P/LSTA Leveraged Loan Index dipped to 76.23 on 23 March from 96.72 at the start of the year). However, sector-specific actions by policymakers and covenant relief activity (c.80 deals since the start of the year) supported the S&P LL Index’s rebound to 86.69 on 21 April 2020. We expect the recovery to continue, although it will likely take longer than it took following the 2008 crisis. We also expect deep discounts in the credit market as CLO managers under stress continue to reduce their “CCC” exposure (they have reduced it by 1.23% since early May 2020 at a cost of 21bps at par).

We believe that in the current scenario, investors can derive higher alpha (which has largely been non-existent in the past decade due to the bull market) by identifying quality LLs on discounted terms and with limited downside risk. We have extensive experience in supporting some of the largest CLO managers globally through our customised leveraged lending solutions.

Originally published at https://www.acuitykp.com.

Sources:

1. OFR FRAC Working Group: Leveraged Lending & CLOs

2. Financial Stability Board

3. Bloomberg: First European CLOs Fail Key Test Amid Strain of Pandemic Impact

4. S&P Global: Covenant relief activity soars on LL; Rebound in credit market; EBITDA add-back analysis finds projections often fall short

6. Under stress: Assessing CLO Manager Performance During COVID-19

7. UBS: Defining credit dislocation

About the Author

Arjun Prasad, Delivery Manager, Investment Research, has over five years of experience in fixed income research, supporting Europe- and US-based CLO managers by identifying suitable investment opportunities after screening and analysing the credit quality of high-yield European and US issuers. His analysis has helped clients to successfully roll out multiple warehouses. He holds an MBA (Finance) and a Bachelor of Engineering degree.

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Acuity Knowledge Partners

Acuity Knowledge Partners

We write about financial industry trends, the impact of regulatory changes and opinions on industry inflection points. https://www.acuitykp.com/