LevFin Lens – CLO Q&A with Morgan Stanley Strategist Gavin Zhu

In an LFI exclusive interview, Gavin Zhu, CLO strategist at Morgan Stanley, discussed the current state of primary senior spreads, particularly focusing on Triple A spreads. At the start of the year, Triple A spreads experienced significant tightening, moving from around 125bps to the low- to mid-110s. After hitting record post-GFC tight levels, resistance has been encountered, and with macroeconomic volatility and resistance in loans and CLOs, new issues might come out slightly wider.

Institutional demand remains strong, driven by banks and insurance investors, with US bank deregulation serving as a significant tailwind for CLO Triple A demand. The sale of fixed-rate annuities has spurred additional interest from insurance companies in securitized credit, particularly CLOs. This trend is expected to persist, especially in a potentially higher interest rate environment. Last year’s net issuance and amortizations were highlighted, noting that heavy amortizations and liquidations created pressure for investors to reinvest cash, tightening spreads. This year, $56bn in amortizations are forecasted, down from $79bn last year, leading to slightly stronger net issuance.

Regarding CLO demand, there’s robust interest across securitized products, with a focus on short-duration paper and CLO equity, particularly from pension funds and international investors. Acknowledging the challenges in sourcing loans, the primary arbitrage isn’t viewed as challenged, as both asset and liability spreads have decreased. Corporate credit fundamentals are noted as strong, with defaults declining, although slight increases in loan downgrades and interest coverage deterioration are observed. Overall, the macroeconomic landscape remains a challenge, yet the underlying fundamentals and demand dynamics provide a stable outlook.

LFI: Could you explain the current base case versus bull case for primary senior spreads, specifically focusing on Triple A?

Morgan Stanley: We began the year with notable tightening in Triple A spreads, which were around 125bps. They quickly moved to mid-110s, and we hit the post-GFC tights. However, we’ve recently hit resistance levels; deals have gone as tight as…