Fair Oaks Reflections – Issue 1

CLO Equity: A Good Time to Invest?

Challenging credit fundamentals, tight credit spreads and volatility can, unsurprisingly, be reasons to justify delaying investment decisions until the market corrects. On the other hand, the opportunity cost of holding cash is high and it is difficult to time investment decisions perfectly, not just in the sense of identifying the right time to invest but also ensuring decisions are made in a timely manner at a time of high volatility. Fair Oaks believes that CLO equity provides a compelling solution to the aforementioned challenges, particularly for investors with a medium-term time horizon.

In addition to offering an attractive return under sensible default and reinvestment assumptions (we estimate that the base arbitrage for a typical CLO is in the 10–12% range), there are unique characteristics of CLO equity that significantly mitigate concerns of weak credit fundamentals and tight credit spreads while CLO equity also has an unusual positive exposure to volatility. The historical return experience for CLOs, particularly for CLOs issued just before the financial crisis, further makes the case for investors to consider the asset class in current market conditions.

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