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by  BlueBay Fixed Income team, M.Shohet Jan 25, 2023

We believe CLO AAA securities, and in particular, US CLO AAA bonds issued in the primary market are one of the most attractively priced securities, on a risk-adjusted basis, available in investment grade credit markets today.

US Primary CLO AAA securities are structured with ~36%-40% credit enhancement, meaning that nearly 75%-80% of the collateral pool would have to default (assuming a 50% average recovery rate on defaulted assets) for a AAA bond to take a principal impairment. In fact, collateral defaults would need to be even higher as there are other structural protections, such as excess cash trap, that provide additional credit enhancement. Consequently, investors benefit from a very significant cushion against a rise in defaults (no CLO AAA security has ever taken any impairment).

We have recently seen a divergence between US Primary CLO AAA spreads, which widened into year-end, and other comparable spreads which saw considerable tightening in Q4 2022. Given the credit remoteness of CLO AAA bonds, the recent widening is in our view the result of technical pressures, as some large buyers have been forced to be absent from the market and thus supply has not been absorbed with demand in the way it has been in the past.

Spreads US CLO AAA vs. Corp

* Represents the spread over LIBOR before 1 January 2022 and the spread over SOFR after 1 January 2022 (the date on which the US CLO Primary Market transitioned from LIBOR to SOFR). Source: Bloomberg, BofA US Corporate Index, Palmer Square CLO Index, Barclays CLO Research.

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