November 16, 2022 - On November 9th, the LSTA. along with a slew of CLO managers, arrangers and investors, welcomed more than 600 Japanese investors to the LSTA Tokyo Loan Investor conference. Here we offer the agenda, the morning and afternoon presentations, and key takeaways.
After a review of the Japanese economy, challenges and opportunities by Robert Alan Feldman (Morgan Stanley MUFG), the conference turned to loans and CLOs. The Broadly Syndicated Loan (BSL) panelists noted that the loan market’s (relative) outperformance this year was mainly driven by its floating rate nature. Managers believed that returns will probably end the year in negative territory and prices in the secondary should remain rangebound in the low-to-mid 90s. They also noted that today’s credit spreads have already accounted for a sharp increase in the default rate (which has not occurred). This alone, has created value, particularly in the BB space where yields are in the 8% range. While panelists did not believe that technical and fundamental conditions will improve in the short term, they did believe that both the primary and secondary markets are well priced right now, given the risks ahead.
The BSL market has come to see Private Credit (PC) as both a complement and substitute. PC has experienced a recent 10-fold increase; indeed, at more than $1.2 trillion of capital globally today, it is close to both BSL and high yield in terms of size. Managers see the BSL and PC markets as a continuum that can coexist and serve specific interests for both borrower and investors needs and under different market conditions. While bankers have expressed concerns that direct lenders are disintermediating banks, they are actively participating in this market in a variety of ways. Of course, private credit is not without challenges: There are concerns that the market may be limited by the scarcity of information and transparency (but the market is dealing with that). Second, defaults (and recoveries) will test credit markets, but panelist believe that the flexibility (and tighter documents) of PC will hold up well.
Two panels were dedicated to CLOs. In the morning was the CLO arranger panel, which discussed how CLO issuance remained remarkably high ($117 billion YTD) even as CLO AAA spreads were well over SOFR+200. The answer included high loan spreads (current levels just about support CLO liabilities spreads), incentives (to clear out warehouses) and print & sprints (when loan prices dip). Panelists reminded the audience that LIBOR transition must happen – but also that many CLOs use hardwired fallback language and thus the liabilities’ base rate would switch to 3M SOFR+26 bps. So where do we go in 2023? Panelists noted that a U-turn in CLO liabilities spreads involved an improvement in the economy, a decline in both geopolitical tensions and inflation, and the return of key investors. In other words, it might be a while.
In the afternoon, CLO managers (and an investor) took the stage. There, the discussion revolved around managing CLOs through a cycle. While CLO AAA liabilities almost assuredly will not see losses – a Barclays stress test couldn’t impair them, regardless of loan default levels – there will be an increase in defaults and CCC assets. Still, managers note that not all CCC loans are created (or downgraded) equal – see the CCC price distribution slide for this – and it’s possible to trade out “bad” secularly-challenged CCCs for “good” cyclically-challenged CCCs. Some panelists also are taking the opportunity of discounted pricing on bonds to trade up in quality (albeit potentially with a bit of challenge to interest coverage). Looking forward, managers are hoping for a faster rebound in the AAA market.
While all panels discussed credit fundamentals, the Credit Cycle panel drilled in, offering challenges – and reassurances. First, panelists note that we are in the downturn phase of the credit cycle, where credit fundamentals (particularly third quarter EBITDA growth) are beginning to weaken across the portfolio. With rates climbing rapidly, interest coverage is a concern; panelists were uncertain about how aggressive the Fed will continue to be and for how long. This fact alone, could drive default rates higher in a hard landing environment. But panelists pointed out that higher yields across the portfolio should be sufficient to counterbalance higher default rates and a wider dispersion in recoveries across the next 12- 18 months.
While market topics are critical, so are exogenous issues like regulation, LIBOR transition and ESG. For LIBOR transition, the adoption of SOFR has been swift and successful in 2022 in both new loans and CLOs. However, remediation has lagged. With just over seven months before USD LIBOR ceases as a panel rate, 85% of CLO loans still reference LIBOR. Certainly, market dislocation has played a part given the limited opportunities for organic transition. For remediation of legacy loans, borrowers hold the keys and borrowers are not moving quickly. Hopefully this changes before the end of the year because borrowers may find it challenging to complete their amendments come 2Q23 if they all head for the exits at once. (And if borrowers don’t get amendment fallbacks completed, they will pay a much higher Prime-based rate.) The sluggishness of the loan market has also delayed remediation in the CLO market. It is now expected that CLOs will not reach their 50% asset percentage trigger for early transition until 2Q23.
Finally, there’s ESG. Certainly, climate finance has been front and center since COP26 and the loan market has its role to play. The market needs better ESG data, however, in order to offer the broad variety of structures and strategies investors would like to see. The ESG Integrated Disclosure Project launched by the LSTA, Alternative Credit Council and UN supported-Principles for Responsible Investments, was created in recognition of the growing need for more robust ESG data and aims to establish a baseline of ESG reporting by borrowers. In addition to such industry efforts, sustainability linked loans (SLL) which marry sustainability performance and disclosure, have hit a record level in the US this year. Standards, in the form of Sustainability Linked Loan Principles, have been an important part of supporting that growth.
All in all, it was an eventful – and information packed – day. The LSTA would like to thank the 29 sponsors and 600-plus Japanese investors that made the 2022 event such a success. We look forward to an even bigger and better event next year.