Cheap European CLOs Offer Investor ‘Carrots,’ Citigroup Says
European collateralized loan obligations are undervalued and investors should take advantage of the biggest discount to U.S. deals this year to boost holdings of the debt, Citigroup Inc. analysts said.
An average AA rated CLO in Europe trades at 64 percent of face value, compared with about 76 percent in the U.S., analysts wrote in a note to clients Oct. 20. Securities rated A trade at 53 percent in Europe versus 68 percent in the U.S.
“Euro CLO liabilities look cheap,” according to the analysts led by Ratul Roy in New York. He cited three “carrots” to tempt investors: the declining cost to convert dollar payments into euros and their discount to both U.S. deals and the debt used to collateralize the notes.
European CLOs have been tainted by the region’s spreading sovereign crisis, though the funds have about 13 percent of their assets in peripheral countries, according to Citigroup. CLOs package high-yield loans into securities of varying risk and return, including equity portions designed to absorb losses first and protect holders of top-rated bonds.
The cost for European banks to fund in dollars rose further today, with the three-month cross-currency basis swap at 93.6 basis points below the euro interbank offered rate from 91.5 basis points yesterday, according to data compiled by Bloomberg.
CLOs in Europe also trade at a wider discount to leveraged loans -- the collateral for the notes -- than in the U.S., Citigroup said. The average price for European CLOs is 81 percent of face value, while loans are quoted at about 90 percent. U.S. CLOs are at 83 percent with loans at 90 percent.
Sales of U.S. CLOs are likely to pick up in the fourth quarter as the funds exploit a 150 basis-point increase since mid-July in the premium loans pay over benchmark rates, Citigroup said. The widening has exceeded that of new CLOs, which have increased an average 80 basis points. A basis point is 0.01 percentage point.
That may push full-year CLO issuance in the U.S. to $12 billion compared with about $5 billion in 2010, Citigroup said.
CLOs are attractive relative to high-grade corporate bonds, the analysts said, with spreads at the widest this year.
“It might be time for insurance companies to come back” after they bought about $5 billion of CLOs in the first half of the year, they said. “Unless rates turn negative, we do not see much upside in corporate bond returns.”
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