1. Current outlook for the equity arbitrage
The CLO equity “arbitrage” (“arb”) is the difference between the term financing costs (i.e., CLO debt coupons) and the credit spread of the underlying bank loan pool. It’s an indication of the level of net income to expect from CLO equity at time of issuance.
Year-to-date 2022, the arb has deteriorated because financing costs have increased relatively more than bank loan spreads. In mid-April, the arbitrage reached 1.75%, near its low over the past five years. In our view, the main technical factor pushing financing costs wider is the Fed’s balance-sheet reduction process, which has squeezed big US banks’ demand for AAA rated bonds. In recent years, US banks have been the largest buyers of AAAs, which are the primary driver of the “all-in” financing cost to equity. We expect this technical pressure to ease in the coming quarters. In fact, there are two catalysts we are watching that could help improve financing costs:
- US bank demand for AAA rated bonds potentially returning as capital ratios improve; and/or
- Wider credit spreads perhaps attracting new marginal buyers, especially US insurers under the new risk-based capital (RBC) framework.
The arb has already begun to correct and is now trading closer to 2.50%, which may translate to new issuance pricing with modeled CLO equity internal rates of return in the low to mid teens.