Economic and Market Commentary

Identifying Opportunity in Bank Loan and CLO Markets

Bank loan and CLO markets struggled in the volatility of Q4 2018, but PIMCO sees three attractive opportunities on the horizon. Alternative Strategist, Nelson Yuan discusses where we are identifying value and how a U.S. recession might affect the CLO market.

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Fourth quarter market volatility in the bank loan market and the CLO market were very pronounced, mostly driven by the equity market volatility and also lower expected earnings growth in the United States.

That volatility caused bank loan prices to have their second worst performance in the last nine years. The S&P/LSTA Leverage Loan Index dropped two and a half percent during December, but early signs in January show a modest recovery in prices which may continue into the first quarter.

CLO markets, on the other hand, saw very little issuance in the course of December, mostly driven by hopes by CLO managers that the markets will improve in the first quarter of 2019. In the CLO secondary markets, both debt and equity prices significantly dropped. And in fact, on CLO equity tranches we saw bid-ask spreads widen to as much as ten points as the market became highly illiquid during the volatility of December.

PIMCO sees opportunities in this CLO market, primarily by being patient but nimble in this marketplace. In particular, we're focused on providing liquidity into a currently very illiquid market.

In order to do that, we need the relationships, the expertise, the speed and capital to take advantage of those opportunities.

Three areas that we find interesting are first, in the secondary market, providing liquidity to force sellers in the marketplace. We haven't really seen them come into the market yet in December, but we expect that as this volatility continues, they will likely become much stronger for sellers.

Second is in doing print and sprint CLO deals where we can currently issue the CLO debt tranches, while also buying at discounted prices loans in the secondary market.

And finally, we think that there are opportunities in buying hung warehouses off of the banks. These are deals where the bank was looking to price the debt tranches but was unable to and therefore looking to sell them to us.

The potential risks for a US recession will have a minimal impact on CLOs. PIMCO's view is that in 2019 the risk of a recession is very minimal. However, in the three-to-five-year horizon we think that there is much more elevated risk of a recession. However, that recession we believe will likely be more shallow but longer in duration compared to the 2008/2009 crisis, mostly because of number one, there being less over-leverage in the market, so therefore less de-leveraging that needs to take place in the market correction; and second, because the policy tools that are available to the central banks are more limited today than they were in 2008 and '09.

From the investor surveys that we've seen in the bank loan market, the expectation for 2019 default rates in bank loans is around 2.1%, which is a little bit higher than the 2018 default rate of 1.6%, but still lower than the 3.1% historical average for default rates in the bank loan market. Given PIMCO's views of a shallower but longer recession, we believe that CLOs are well positioned to still be very profitable for investors during the course of the next three-to-five years.

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