August 4, 2022 - Riddle me this: How can CLO AAA spreads be at (a near-record) 220 bps over SOFR and yet year-to-date CLO issuance be off just 9% from (record) year-earlier levels. According to LCD, YTD US CLO issuance through July 29th was $84 billion, off just 9% from 2021 levels (the highest year on record). With liabilities spreads providing considerable headwinds – more on this later – one would think CLO formation must slow. And indeed, so thought many CLO analysts, who largely cut their 2022 FY issuance forecasts in recent months. But with CLO flow topping $80 billion recently, some capitulated and brought their estimates back up. After dipping earlier this summer, JPM’s issuance forecast sits again in the $110-120 billion range, BofA is in the $135-145 context, Citi has reduced incrementally from $165 billion to $120 billion and Morgan Stanley has remained firmly in the $140 billion context.
These volumes are nominally surprising considering the spreads. At SOFR+220 and change, Refinitiv observes (and charts) that AAA spreads are nearly twice the level seen at the beginning of the year. Morgan Stanley adds that, aside from brief Covid wides in 2Q20, these are the highest AAA spreads ever seen. But why? For one, several natural buyers have retreated, BofA notes. First, banks, particularly GSIBs, look to be reducing risk weighted assets after the latest round of stress tests. This could impact their appetite for AAA notes (and CLO warehouses and loan trading, for that matter). Meanwhile, Japanese buyers have pulled back, in part due to uneconomic JPY hedging costs. And what of the remaining buyers? Morgan Stanley notes that they may be waiting for even better terms; according to ABS Vegas scuttlebutt, while investors like current levels, they may love the opportunities that may be coming soon.
While the liabilities stack is challenging, what’s happening on the asset side? With recession talk in the air, observers are watching loan quality. Unsurprisingly, downgrades have been outpacing upgrades. S&P reported that CLO obligors saw 16 downgrades and 13 upgrades. LevFin Insights drilled into the all-important B-/CCC cusp in the CS Index and noted that there were 12 downgrades and four upgrades in this neighborhood in July.
But there’s more than downgrades in CLO collateral; there are increasing numbers of bonds there too. Nomura reported that bond holdings increased from practically nothing a year ago to roughly 0.75% of BSL CLO collateral. On the quality front, the bond ratings skew higher; eyeballing a Nomura chart, it appears that less than 15% of CLO bonds are rated B- or lower, versus 30% of CLO loans. Meanwhile, BofA spotted AA+ rated Apple and AAA rated Microsoft bonds in some portfolios. That presumably doesn’t hurt the WARF (or the OC if purchased below par).
What’s not in abundance in CLO collateral? SOFR loans. JPM reported that 13% of CLO collateral is now priced over SOFR. (Trustee reporting is a bit lagged; that said, market-wide SOFR exposure is still underwhelming at 14% in the JPM Leveraged Loan Index.) With the loan market dislocated and new issues clearing in the low 90s, it’s unsurprising – though also unfortunate – that few borrowers are refinancing organically into LIBOR. But while the slow pace is certainly understandable, it simply means the transition crunch will be worse next year.