The withering mid-summer market conditions for CLOs may merely be a precursor to malaise and uncertainty for the industry in the remainder of the year.
Many CLO platforms are on hiatus due to excessive deal costs and elevated spread conditions. Previous investors in CLO debt and equity offerings also remain on the sidelines, reluctant to take on corporate-loan risk amid macroeconomic and credit-quality worries.
Issuance forecasts for the remainder of the year (building on $55.56 billion in activity in 1H23) have been trimmed by multiple credit market research analysts to approximately $100 billion, a steep year-over-year decline in new deal activity and a primary reason for a potential first-ever, post-Global Financial Crisis decline in net CLO supply next year.
“Arbitrage levels are well below the break even for most deals and equity buyers remain scarce,” wrote global CLO analyst Conor O’Toole in a June 13 mid-year CLO industry outlook published by Deutsche Bank.
“Our expectation is that issuance will muddle along,” said Philip Raciti, head of performing credit and portfolio manager at alternative asset manager Bardin Hill Investment Partners, in an interview with LCD.
After second-quarter deal volume fell by nearly half to the comparable period in 2022, bank analyst projections have now essentially aligned behind a full-year 2023 CLO issuance estimate of approximately $100 billion, versus $128.97 billion in 2022. Analysts with JP Morgan and Barclays in June came off their relatively bullish forecasts of $115-125 billion entering 2023; JPM cut its outlook to $100 billion, while Barclays circled a range of $80-90 billion.
“I think a lot of it [also] has to do with the sponsor activities,” said Jim Fellows, chief investment officer for First Eagle Alternative Credit and head of its tradeable credit team. “Just like the CLO equity arbitrage, the math doesn't work for sponsors. The valuations haven't come down enough for their returns to work, given the fact that the cost of capital has risen considerably.”
Greater tiering in spreads
The average CLO triple-A spread in 2Q23 was 198 bps over term Sofr, and 195 bps in June.
Those spreads represented a slight widening from 1Q23 levels, and are still well above the early 2022 levels that managers attained for standard-term CLO structures (two-year non-call, five-year reinvestment periods).
In its June monthly market update published July 5, Barclays credit market analysts estimated that generic BSL CLO spreads improved across the stack despite the decline in primary activity. Triple-A coupons fell to Sofr+181 bps, from Sofr+199 bps in May, the sharpest tightening of any tranche, as the weighted average coupon cost was lower by seven basis points (to 251 bps) for the month.
JP Morgan fixed-income analysts estimate that year-end spreads for tier-one CLO AAA paper will tighten to about 170 bps, which will lengthen the gap in AAA spreads against less-frequent issuers who are still pricing deals well wide of 200 bps. JPM projects a high-tiering basis of 40-50 bps to continue into next year.
Looking for buyers
Market observers attribute the difference to the restrictive investment choices of Japanese bank investors, an important AAA investor base that works primarily with larger managers that have traditionally sponsored the bulk of CLO portfolios. “The market in the last two or three months has really been driven by Japanese access,” said one US portfolio manager. “The problem is, less than 20-25% of the managers are on their approved list of issuers.”
“We’ll need to see better demand for triple-As to help improve the cash flow arbitrage of CLOs,” said Joseph Rotondo, senior portfolio manager for MidOcean Credit.
CLO market activity has historically been buoyed by heavy refinancing activity, such as the $250.88 billion in refinancing and reset actions taken by US managers in 2021 taking advantage of low spread conditions to lock in lower-cost, Libor-based coupons at that time.
But with the onset of market volatility in the spring of 2022, refinancings and resets all but disappeared as rising interest rates take most deals out of the money for a repricing at current levels.
Many expect CLO resets and refinancings to remain rare, despite the accumulation of deals reaching the end of reinvestment periods by year’s end. Estimates are up to 40% of outstanding CLO vehicles could enter amortization or liquidation instead of traditional refinancing or reset options.
CLO resets and refinancings “remain out of the money,” Deutsche Bank’s O’Toole wrote in his outlook report, “and we expect this to persist barring a significant and sustained spread tightening event, which seems unlikely.”
“I think the focus is going to be refinancing ’24-’25 maturities the rest of the year,” said Ivo Turkedjiev, managing director with New Mountain Capital.
The exception may be about $20 billion in short-term and static 2022-vintage CLOs that priced with non-call periods of one year or less in the latter half of the year at elevated spreads.
“There are some deals that will be able to amend and extend and keep reinvesting for another few years,” said Nirjhar Jain, sector head of CLOs at LibreMax Capital. “[But] some of these deals will be left with, essentially, tail risk” for underperforming loan assets.
Weak supply
The dynamics of the leveraged loan market, for which CLOs are a key driver for issuance, have also been out of kilter. Loan issuance dipped to $47.7 billion in the second quarter, from $52.4 billion in Q1, dominated by refinancing ($67.2 billion), amend-and-extend ($34.4 billion) and add-on transactions, rather than the M&A borrowing ($13.2 billion) that has traditionally fueled the market.
“The [loan] market has not been significantly out of balance one way or the other,” said Dominick Mazzitelli, chief investment officer and head portfolio manager of LibreMax Capital’s CLO management business, Trimaran Advisors. “New issue supply is down and demand is down.”
Although returns on loans are at their highest levels since the Global Financial Crisis (up 6.48% in the first half), according to LCD, lending conditions have tightened on borrowers and the population of companies with the riskiest credit profiles continues to surge in the market. A record 36% of the Morningstar LSTA US Leveraged Loan Index is made up of firms rated B-minus or lower.
Middle-market CLO boom
While broadly syndicated CLO issuance remains challenging, middle-market and private-credit CLOs are experiencing resurgent interest from investors.
Middle-market deal activity totaling $11.39 billion across 24 deals represented 20.5% of CLO market share in the first half of 2023, nearly double the share MM CLO sponsors have taken up in previous years. Deutsche Bank estimates middle-market CLOs are on track for $23 billion in issuance by year’s end.
“We’re seeing a lot more crossover buying from BSL investors to middle markets,” said Michael Herzig, senior managing director, head of business development at First Eagle Alternative Credit.
Private credit lenders are “definitely stepping in in place of banking commits, and it's been a good counterbalance,” said Bardin Hill’s Raciti. “They've been very selective on assets. ... Quite frankly, there is an increased need for some of the shorter duration, B3 [rated] assets out there that private could probably help sell.”
Credit conditions worsen
The market has long expected defaults among CLO obligors to rise, as Fed interest-rate hikes and inflationary trends impact revenues and raise the cost of servicing and obtaining debt. Deutsche Bank expects leveraged loan default rates to reach 3.5% in 2023, before peaking at 6% in 2024.
“Recoveries when companies do default will be lower than historical averages and the range of outcomes will be greater,” the bank’s mid-year outlook stated. “Negative rating migration on loan portfolios will also rise, pushing up CCC buckets.”
The default rate by amount climbed to 1.71% in June, from 1.58% in May, for the Morningstar LSTA US Leveraged Loan Index, as the trailing 12-month default volume total ($24 billion) reached its highest level in more than two years.
The index’s default rate is expected between 2.50-2.99% by this time next year, say respondents to the Q2 US LCD Leveraged Finance Survey published at the end of June.
Loan market participants are also pessimistic over the odds this year of finding a painless reversal of inflation — now coined “immaculate disinflation” in the marketplace. Eighty-seven percent of respondents to the LCD Q2 survey gave this scenario a 25%-or-less chance of occurring.
Hopeful signs
Although major money-center banks have been absent from the institutional buyers’ market for approximately a year, the results of 2023 Fed stress tests “passed” by major US banks could bode well for their return to the CLO market, Barclays credit analysts noted in a July 5 CLO and loan industry report.
All 23 banks were able to withstand hypothetical scenarios of a recession or other financial-market shock while maintaining minimum capital requirements, the Fed announced June 28.
The results are potentially “tailwinds for CLOs in the near term if a cohort of the banks resumes CLO buying activity,” according to the Barclays biweekly CLO technical and relative value market study.
CLO AAAs also maintain strong relative value to corporate investment-grade or other triple-A investment options. EU and US CLO AAAs were among a selection of assets Morgan Stanley analysts picked to bring total returns of 6% or more through the second quarter of 2024. “While we see leveraged credit underperforming as growth slows,” according to a June 4 global strategy mid-year outlook report from the bank, “we think CLO AAAs are sufficiently risk remote. All-in yields of ~7% are highly attractive for low duration.”
Featured image by Iakov Kalinin/Shutterstock
This article originally appeared on PitchBook News
