Earlier today, we noted that Citi can’t believe how enticing CLO mezz tranches have become.

“Can CLO mezz get any more attractive?” the bank’s structured credit team asked. You’d be forgiven for being a bit incredulous. After all, CLO 2.0 mezz hasn’t exactly been somewhere you want to be. As Morgan Stanley noted last week, “the median total return for US CLO 2.0 (2014-15 vintage) BBs is -9.2%, and for single-Bs is -20.9%.”

Morgan continues: “Investment-grade US CLO tranches performed better but still within negative total return territory, [and] collectively, US CLOs significantly underperformed relative to comparably rated corporate bonds, leveraged loans and senior tranches of CMBS.”

Right. So bad news all the way around.

But you know, you want to look for BTFD opportunities anywhere you can find them and despite the fact that subordinate CLO tranches are about the most ludicrous recommendation imaginable in the current environment, Citi thinks maybe you should have a look because after all, how much wider can US CLO 2.0 spreads possibly get relative to other probably terrible investments? Here’s Citi to explain why there’s value here if your benchmark is HY and/or subordinate CMBS tranches:

CLO BB spread has widened by 275bp to 1000-1500bp range since the start of 2016, already surpassing the 172.5bp widening observed in the full year of 2015. To put this into a broader context, CMBS BBB- also widened by about 260bp to 800bp and HY by 130bp to 876bp. CLO mezz appears cheap to loan and HY, but not so much to CMBS mezz.

 

 

Near-term CLO mezz spread movement will largely depend on the market supply and whether the demand from non-traditional or opportunistic buyers will be in place timely to absorb that. Oil price and broader market performance/fund flows are the wild cards. There would be opportunities for the investors to step in and scale up as price downside risk lowers, but the market volatility is likely to persist. Incoming investors should weigh the return with risk management.

Yes, “incoming investors” should “weigh return with risk management,” because if the assets in the collateral pools continue to be downgraded, you’re going to see continued underperformance and make no mistake, there’s no reason whatsoever to expect that the downgrades aren’t going to continue. 

Additionally, Citi says BBs are at risk of forced selling by money manangers. Here’s more:

There is about $16.7bn CLO 2.0 BB outstanding [and] based on our primary investor base data and reported fund holdings on IPREO, we estimate roughly $4.3bn is held by hedge funds, $7.1bn by asset managers and $2bn by mutual funds ($1.7bn in open end mutual funds). Assuming two thirds of hedge funds and 20% of asset managers used leverage, our best estimate is perhaps $4.3bn of CLO 2.0 BB bonds were bought with leverage and $1.7bn in open-end mutual funds. Some of these investors might consider selling ahead of more volatility.

So far, TRACE reported $3.4bn non-IG rated bonds traded YTD altogether but doesn’t break into CLO BB, B and equity tranches. If we assume the same rating breakdown as in CLO BWIC traded volume, it means $2.7bn BB, $0.2bn B and $0.5bn equity could have been sold already. If so, it is fair to say more supply can come with leverage unwinding.

Repo desks typically require investors to post daily margin if the portfolio price swing is too big. Given the median CLO 2.0 BB price has dropped about 16 points from $94 in May 2015 to $78 at the end of January 2016, our analysis shows some investors probably have posted 40-60% more capital just to meet margin calls by now, depending on the haircut and price movement (Figure 19). A further price drop in CLO junior debt might, in some cases, require holders to put down more capital than their original investment to meet the margin calls.

So be our guest. Lever up in junior US CLO tranches. It should be fine. 

Of course if it turns out poorly you’ll look like the biggest sucker on the planet because you should be able to divine something about the suitability of an investment by observing supply and demand dynamics. Here’s what the picture looks like for US CLOs:

Again: trade accordingly.