Split senior tranches return to US CLO market as spreads grind tighter
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Split senior tranches return to US CLO market as spreads grind tighter

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Portion of investors trade credit enhancement for spread in hunt for yield

Investors searching for a safe place to put money that earns a higher yield are fuelling a comeback in split senior tranches — where senior and junior triple-A rated tranches within a deal have similar credit profiles but pay different spreads.

Of the 16 new issue CLOs that have hit the market in the past seven days, three of them have been structured with dual triple-A tranches, a departure from the usual single, big triple-A slice.

Deals with split triple-A rated tranches typically account $2bn-$4bn of the US CLO market but, according to Bank of America, that volume has risen 40% this year.

Deals with split triple-A rated tranches accounted for almost $4bn of the US CLO market in 2018 and 2019 but, according to Bank of America, that volume dropped to 2bn in the year of the pandemic.

Tightening spreads since then and elevated CLO activity have seen a return of the feature.

Bain Capital, Ares Management and HalseyPoint Asset Management have all issued such deals. Moreover, Marathon Asset Management deployed the technique on November 10 when it priced the the first CLO with a tranche tied to the Secured Overnight Financing Rate, or Sofr.

The idea, said a CLO manager and investor, has been for issuers to make more efficient use of the capital stack and to be able to issue a "junior triple-A less expensive than double-As but wider than first priority triple-A."

The pricing differential is achieved by selling to investors who will accept lower credit enhancement on triple-A paper, typically money managers.

Credit enhancement levels on triple-A rated notes is high — generally the notes can take losses of 35%-38% of par before any loss of principal is incurred. But not every investor wants that much protection.

"Some triple-A investors negotiate how much par subordination they get," said the CLO manager and investor, and generally the issuer will consider the trade-off between improving the credit rating of a particular note classes versus the reduction in yield.

Bank of America analysts suggested the spread differential between senior and junior triple-A rated tranches stands at around 25bp-35bp.

HalseyPoint CLO V included a $305m of paper rated Aaa by Moody's and sold at 121bp over three month Libor, with credit enhancement at 38%.

A $15m junior Aaa-rated tranche was sold at 150bp over three month Libor and 35% of credit enhancement.

Alongside the floating rate notes, the deal also included a $5m senior tranche at fixed 2.52% interest.

Ares issued its CLO LXII with a $369m senior tranche, rated AAA by S&P and Fitch, priced at 113bp over three month Libor that benefited from credit enhancement, or loss absorption. of 38.5%. The junior triple-A tranche, rated only by Fitch, was a $21m slice sold at 145bp over three month Libor with credit enhancement of 34%.

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