Yield Book’s Luke Lu and Miles Li analysed monthly WAS and WARF metrics to discover more insights into CLO managers’ style of risk-return preference and their evolution over a three-year period.
- Active management by CLO managers allows for flexibility during periods of market stress.
- Seven out of 98 CLO managers consistently outperform their peers.
- Some managers sacrifice a certain amount of return to limit credit risks.
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The collateralised loan obligations (CLOs) market – typically known for its relative stability, resilience and attractive yields – has seen market sentiment weaken due to a myriad of headwinds.
It has borne witness to major market events in recent years – a global pandemic, war in Ukraine, soaring inflation and climbing interest rates.
Yet default rates are low and within this volatile environment, some CLO managers outperformed their peers by actively managing their portfolio and adjusting their investment styles to reflect market stresses.
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Risk-return analysis for CLO assets
To explore this further, we took an in-depth analysis of the weighted average spread (WAS) and weighted average rating factor (WARF) trade-off, which exemplifies risk-return analysis for CLO assets.
The WAS represented the excess return (on top of underlying benchmark index rate) from the collateral pool and the WARF indicated the associated credit risk. This WAS/WARF analysis clearly highlights the market evolvement and the CLO managers’ risk-return preference.
WAS/WARF analysis paints the 2022 risk-return picture
In an ideal scenario, CLO managers would prefer a portfolio with high return (i.e., high WAS) and low risk (i.e., low WARF), but this can be unrealistic in most cases because higher quality (higher ratings) assets typically come with low spreads.
While some managers will sacrifice certain amount of return to limit credit risks, others with higher risk tolerance will buy lower quality collateral in pursuit of a higher yield.
First, we took the monthly WAS and WARF metrics for the past three years (2020-2022) across 98 CLO managers, and averaged the data by weight of deal collateral par. The managers were distributed into four quadrants by their deviation from the median from WAS and WARF.
Quadrant 1: High risk/low returns (higher WARF and lower WAS)
Quadrant 2: High risk/high returns (higher WARF and higher WAS)
Quadrant 3: Low risk/low returns (lower WARF and lower WAS)
Quadrant 4: Low risk/high returns (lower WARF and higher WAS)
More than half or 59 CLO managers moved quadrants, out of which 14 gained a spot in quadrant 4 from 2020 to 2022 and were able to achieve a better return for risk they took.
Over the three years, only seven out of 98 CLO managers outperformed and remained quadrant 4 (high WAS and low WARF), while 39 managers were consistent in their WAS/WARF preference over the three-year period.
The median WAS cut-off was 3.54 percent in 2020, jumping to 3.70 percent in 2021, but shrinking to 3.58 percent in 2022. The median WARF cut-off started from 3101 in 2020 and sliding to 2900 in 2021 and 2795 in 2022.
In 2020, rapid downgrades of many CLO assets resulted in a rise in ratings factor, while in 2022, many CLO managers took a conservative approach by investing in less risky/higher quality assets.