At 430 bps, the spreads on BBB-rated US CLOs remain well above BBB bonds (140 bps) and even split-rated BBB/BB loans (270 bps) – see chart 10 above for overall CLO yield context. There are various reasons for this anomaly, including higher flows-driven volatility.
From the pure credit loss-perspective, the BBB CLO tranches are extremely resilient thanks to structural features, such as diversification of underlying loans across obligors and sectors, overcollateralization and credit support of junior tranches. In addition, active management and rebalancing of loans further mitigates losses and increases yield.
The credit resilience can be illustrated by stress-testing CLOs for expected returns under different annual default rates (held constant over the remaining life of the CLO). As evidenced on the charts, the expected returns, when priced at the current 430 bps spread, start collapsing only after higher than 10% default rates on the 2023-issued vintage. The more seasoned, and thus further de-levered, 2019 vintage does not start reducing returns until 15% default rates are reached. These scenarios represent extreme conditions with default rates held permanently higher than even the worst short term default spikes during 2008 GFC.
Read more in our Alternative Credit Letter
