Even though the first-loss tranches of collateralized loan obligations have been responsible for keeping some deals from coming to market all year, the double-B and triple-B tranches of deals that have gotten off the ground are being touted as some of the best picks for the final quarter of 2002. According to Lang Gibson, director of structured credit research at Banc of America Securities, there is real value in these tranches of CLOs, which offer high risk-adjusted returns.
As BB and BB- loan spreads have remained tight in the range of 250-350 basis points over LIBOR, high-yield CLO equity returns have held steady in the 12-20% range. Those returns are still attractive on a risk-adjusted basis due to the relative stability of collateral spreads, relative low incidence of collateral defaults and high senior secured recovery rates, Gibson noted.
The point when spreads begin to diminish for double-B and triple-B tranches of CLOs occurs when there is a 7% and a 15% assumed constant annual default rate (CADR), respectively (see chart). Gibson said that, compared to an outright loan portfolio yielding LIBOR plus 3%, the double-B CLO tranches yield LIBOR plus 8% and don't break even with the loan portfolio until reaching an unheard of CADR of 14%. The triple-B CLO tranches offer approximately the same spread as the loan portfolio, but the breakeven point is an outstanding 30%, he noted.