May 19, 2022 - Through last week CLO issuance volumes were solid – though this may not last – even as new issue liability spreads had widened substantially. While today’s environment certainly is challenging, analysts feel that the CLO structure has been fire-tested and should remain sturdy even as if loans come under pressure. We detail the stats and views below.
First, the stats: According to LCD, as of last week, year-to-date US CLO issuance topped the $50 billion mark, down “just” 17% from the $60 billion closed the same time last year. But this week is quieter and a split is emerging on whether the flow continues. After all, CLO note spreads buckled and gapped in recent weeks. According to Bank of America, last week CLO AAA-A spreads gapped 23-45 bps and generic secondary CLO AAA spreads were in the 170 bps context; this means CLO spreads are wider than nearly all similarly rated structured products and corporates.
In the CLO primary, we are seeing AAA spreads in the mid-to-high 150 bps range (often married to undisclosed discount margins) and sometimes with short-dated reinvestment periods. Morgan Stanley observes that the technicals will be a headwind for CLOs this year, with fixed income investors seeing other opportunities to deploy capital. On the other hand, there are a number of open warehouses and CLO equity investors might want to switch to SOFR ahead of LIBOR cessation next year. Net-net, Morgan Stanley anticipates approximately $140 billion of full year 2022 new CLO issuance, but more modest refinancings ($25 billion) and resets ($80 billion).
As for CLO performance, (most) analysts are (relatively) sanguine. Admittedly, Barclays sees CLOs’ distressed assets (those priced under 90) rising to 6% in April from 3% in March, LCD reported. But the whole secondary market has softened, with the average bid in the S&P/LSTA Leveraged Loan Index sitting at 95.04 as of May 18th. Such price points may well indicate credit stresses, but they may also reflect a generalized market sentiment. And while one can – and does – calculate CLOs’ NAVs and Market Value Overcollateralization (MVOC), the vehicles fundamentally are about credit. So, what can one expect with respect to credit?
According to Fitch, the TTM leveraged loan default rate is 0.8% and the full-year forecast is 1.5%. In fact, according to Refinitiv LPC Collateral, the amount of defaulted loans in CLOs actually declined nearly 40% (to $1.95 billion) in April as CLO managers traded out of about $920 million of Diamond Sports Group following its distressed exchange. JPM drilled into ratings and default analytics in reports available through mid-May. Looking at all cohorts, JPM sees the Moody’s Caa1 and lower holdings averaging 3.47%, the S&P CCC+ and lower holdings averaging 3.78% and the average default holdings sitting around 0.13%. And even if defaults do climb – which they almost assuredly will – most CLO notes still will be just fine. Both Nomura and Morgan Stanley just tested the levels of defaults and recoveries necessary to break (impair) CLO notes at various levels. According to Nomura, assuming an annual 20% loan repayment rate and a 70% recovery given default, it is not possible to break a sample of recently issued CLO AAAs. To break such a CLO AAA, one must move the loan repayment rate down to 10% and the recovery rate down to 60% – and then one still needs an annualized 60% default rate. Most CLOs perform well even further down the capital stack. According to Morgan Stanley, assuming a 15% annual loan repayment rate, 60% recovery, no call and reinvesting assets at current weighted average spreads, “the median BB [note] across vintages is capable of withstanding 7% defaults per year for the life of the deal.” While one must not be complacent, such elevated default rates for extended periods have not occurred in the history of the institutional loan market.