Collateralized Loan Obligation (CLO) Views—Q1 2021

    Franklin Templeton Fixed Income

    With US election volatility mostly behind us and positive COVID-19 vaccine news beginning to flow through, we believe the outlook for CLOs is brighter on the horizon. We do not underestimate the likelihood of short-term setbacks from rising COVID-19 cases as we progress through winter, logistical issues around vaccine availability or the prevalence of vaccine hesitancy among broad swaths of the population, at least initially. However, as we move past the next 3-6 months, we believe positive news will continue to support recovery and propel spreads tighter.

    Technicals have also proven to be a positive tailwind for CLO spreads over the past several months, and we believe this will continue through 2021 as the new issue market continues to open. While CLO spreads at the top of the stack have kept pace with other credit sectors and have recovered over 90% of their spread widening, lower-quality tranches that are more sensitive to underlying loan fundamentals have lagged as COVID-19 stresses persist. Along with dispersion across the stack, there is also dispersion across managers. As the market continues to heal, we anticipate compression in both and would be comfortable stepping down in quality. Given our constructive view for 2021, we are comfortable going down the stack to single-A and BBB tranches but continue to focus on top-tier managers where potential upside within COVID-19 affected industries is present. We believe these lower-quality tranches will outperform as recovery gets further priced in.

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    Visit Global Fixed Income Macroeconomic & Sector Views: Q1 2021 to learn more about our outlook for each sector.

    Last quarter, we saw marked improvement in CLO fundamentals across various metrics. As we progressed through Q3 2020, we continued to see strong performance within the loan sector which tapered off in October. The impact to CLO fundamentals was marginally positive overall but lacked the large strides we saw in the previous quarter. While these metrics bear watching, asset prices of the underlying loans in US BSL CLOs show nearly a full recovery back to the pre-COVID-19 distribution, with only 3% priced below $80, below which loans are typically categorized as distressed.

    Looking forward, continual improvement in CLO fundamentals is not a given. However, we are optimistic on the prospects and continued spread tightening remains our base case. While we are still awaiting clarity on the makeup of the Senate and the new Biden administration as well as COVID-19 contagion over the winter and the timing of a vaccine, we have seen meaningful progress and believe positive developments will continue to drive improvement in the economy through 2021, which will feed through to CLO fundamentals. Transportation, hotels/gaming/leisure, retail and energy remain the most sensitive industries to COVID-19 disruption. While these industries only represent 12.2% of CLO exposure, three of these industries are among the four with the highest amounts of distressed loans. We still have substantial challenges before we can put COVID-19 in the rearview mirror, but as progress continues and we are able to catch up with COVID-19, we believe the recovery in these industries will propel CLOs forward. Defaults have been fast and furious in energy and retail and much of the default risk in these industries has already been realized. On the other hand, transportation and hotels/gaming/leisure have held up throughout given higher average credit quality. Looking forward, while we may certainly hit more bumps along the road, these industries have already taken a beating and what remains is slightly more fortified.

    2021 brings along concerns about impending changes to policy from the incoming Biden administration; however, these changes are contingent on the resulting makeup of the Senate post the Georgia runoff election in January. We view a scenario where Republicans hold onto the majority in the Senate as a slightly more positive outcome for CLO assets, as it reduces the likelihood of negative regulatory changes targeted at the energy, technology and pharmaceutical industries. In addition, this reduces the risk of a large-scale increase in corporate taxes which should benefit corporates overall. Regardless of the outcome of the Senate race, the tech industry faces additional hurdles from heightened scrutiny and impact from US-China trade policy. However, we view the Biden administration as slightly more favorable on both fronts than the status quo. In particular, the more collaborative approach to US-China trade policy should positively impact tech.


    WHAT ARE THE RISKS?

    All investments involve risks, including possible loss of principal. Municipal bonds are sensitive to interest rate movements, a municipal bond portfolio’s yield and value will fluctuate with market conditions. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. The price and yield of a MBS will be affected by interest rate movements and mortgage prepayments. During periods of declining interest rates, principal prepayments tend to increase as borrowers refinance their mortgages at lower rates; therefore MBS investors may be forced to reinvest returned principal at lower interest rates, reducing income. A MBS may be affected by borrowers that fail to make interest payments and repay principal when due. Changes in the financial strength of a MBS or in a MBS’s credit rating may affect its value. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Investments in emerging markets involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size and lesser liquidity. Investments in fast-growing industries like the technology sector (which historically has been volatile) could result in increased price fluctuation, especially over the short term, due to the rapid pace of product change and development and changes in government regulation of companies emphasizing scientific or technological advancement. Changes in the financial strength of a bond issuer or in a bond’s credit rating may affect its value. High yields reflect the higher credit risks associated with certain lower-rated securities held in the portfolio. Floating-rate loans and high-yield corporate bonds are rated below investment grade and are subject to greater risk of default, which could result in loss of principal—a risk that may be heightened in a slowing economy.

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