April 29, 2021 - by Meredith Coffey. So far, 2021 is looking much better than the same time last year. Happier default data – and perhaps less-happy inflation and interest rate expectations – are bringing loan investors back in droves. Below we consider the credit and investor environment.
On the credit side, the forecasted 2020 default rates never materialized and forecasts have become materially sunnier. This week, Fitch nearly halved their YE 2021 loan default forecast to 2.5% (from 4.5%) and further reduced their 2022 loan default forecast to 2.5-3.5% (from 4-5%). And they see upside risk, noting that a “continuation of the current strong economic backdrop could result in the rate dropping even lower to around the 1.8% mark”.
While those numbers are good, the default rate in CLO portfolios are (necessarily) even better. In March, LPC Collateral said that nearly 50% of CLOs had zero defaulted assets and another 38% had less than 1% defaulted assets. In contrast, only 14% of CLOs had no defaulted assets last August. And CCC holdings, which can be troublesome for OC tests, have dropped as well. Bank of America estimated that more than 30% of “issuers rated CCC any time post COVID have exited the CCC bucket via refis/upgrades”.
Combine improved credit quality, solid performance during the pandemic, a search for yield and an expectation of rising interest rates, and you have all the makings for a bang-up year for loan investment. And, indeed, as the COW demonstrates, investor demand has been fast and furious so far this year. Compared to early 2020, when CLO issuance was lackluster (at best) and loan mutual funds suffered dramatic outflows, 2021 has enjoyed an embarrassment of riches. Through late April, LCD has seen more than $46 billion of new CLO issuance and Nomura tracked more than $47 billion of CLO refinancings and $40 billion of resets. With strong investor appetite, Nomura believes that new issue could hit $105 billion for the year. BofA, meanwhile, has the “over”, revising their 2021 new issue and refi/reset projections to $140 billion and $220 billion, respectively. And so, LPC Collateral’s $766 billion of outstanding US CLO AUM may be set to grow.
But it’s not all Easy Street for CLOs. Another challenge looms in the form of LIBOR transition and a “multi-rate” (and potentially higher basis risk) environment. On the “multi-rate” front, by year end we are likely to have at least two types of rates in CLO portfolios: LIBOR on legacy loans and replacement rates on new loans. This could make CLO administration and tests more complicated.
On the basis front, CLOs currently have LIBOR-based assets and LIBOR-based liabilities. To be fair, there is 1M LIBOR-3M LIBOR basis, which has squeezed CLO equity in the past. But that may be simple relative to the basis that may lie ahead. The loan market currently considering SOFR and Credit Sensitive Rate (CSR) replacement rates. If new CLOs liabilities reference SOFR (which they are likely to do) and CLO assets reference SOFR (which they may do), there is very little basis. (The April 16th COW shows how all SOFRs are similar.) However, if CLO liabilities go to SOFR and CLO assets go to CSRs, that does introduce CSR-SOFR basis. While this likely can be hedged, it introduces a new cost and new complexity into new CLOs.
Bottom line: So far in 2021, it has been a bang-up year for CLOs. But practitioners should keep an eye on the more complex years to come.