by Mike Kurinets, Chief Investment Officer.
In this month’s CLO Insider, we explore how the leveraged loan and CLO markets responded to November’s optimistic CPI report. For the first time in six months, the CPI fell below 8% in November. This news caused the leveraged loan and CLO markets to rally, as it seemed increasingly possible that the Fed could engineer a ‘soft landing.’ Nevertheless, by the end of the month, market participants realized that inflation remained high and that future rate hikes would be inevitable. Even so, leveraged loan prices increased by 0.6 points in November and CLO liabilities tightened by about 15 bps. In turn, CLO equity prices rose and volumes increased in the secondary market, but new CLO issuance remained low due to the challenging conditions for new-issue equity arbitrage.
CPI Report Sparks Temporary Rally
In November, the market saw hope for a soft landing
Throughout 2022, concerns about high inflation -- and fears of aggressive Fed policy to manage it -- have caused a sell-off in loan prices. The downturn began in February when the Fed started to hint at impending rate hikes, and in March when the first rate hike arrived. The downturn worsened in the spring, when the CPI exceeded 8% and rate hikes accelerated. From May to October, the leveraged loan market dropped by over 5 points. During this time, the Fed implemented six rate hikes (the last four of which were 75 basis points each), raising the rate from 0 to 4%. In addition, the Fed implemented a quantitative tightening policy, which is expected to have the effect of raising rates by an additional 0.25 to 0.5 points.
For months, the market had hoped that inflation would fall in response to the Fed’s activity. However, since April, inflation has hovered above 8% (and above surveyed expectations) [*1]. Finally, in November, the CPI dropped below 8% (and below economists’ expectations), offering the market relief.
In response to this optimistic CPI report, leveraged loan prices rose by 0.9 points during the first half of November. The CLO market also reacted. Top quality BBs traded as much as 100 basis points tighter, and CLO equity prices rose too. Dealers noted that customer participation on bid lists increased as it seemed like buyers were beginning to ‘come off the sidelines.’
However, November’s CPI was only a single data point indicating that inflation may have peaked. Inflation remains high relative to rates, and future rate hikes are inevitable. With that realization, loan prices gave back some of their intra-month gains towards the end of November.
CLO junior mezzanine debt and CLO equity outperformed the top of the capital structure
By the end of November, loan prices had risen by about 0.6 points. However, the prices of BB and B rated loans were responsible for the bulk of the increase. In fact, the prices of CCC and defaulted loans declined in November. Since these lower rated loans generally trade at lower prices, credit tails in CLO portfolios did not decrease [*2].
Faced with a modest rise in loan prices but no decline in tail risk, CLO credit spreads reacted significantly. Top quality BB CLOs tightened by as much as 100 basis points, top quality BBB CLOs tightened by approximately 75 basis points, and better performing CLO equity traded several points higher. These trends suggest that the CLO market has concluded that the possible hard landing may not be as severe as the market anticipated in Q2 and Q3 of 2022.
Despite these positive signs, the market’s tone was not fully bullish in November. During the second half of the month, credit spreads largely stabilized as loan prices gave up some of their intra-month gains. Nevertheless, large investors came off the sidelines to purchase well-performing CLO junior mezzanine and equity tranches.
CLO equity trading volumes returned in November, and BB volumes remained strong
For the first time in months, we saw a substantial supply of CLO equity available on bid lists. Nearly $400mm in CLO equity was available in November, with nearly equal volumes during the first and second halves of the month [*3]. However, trading remained challenging in November, as roughly 25% of the supply of CLO equity on bid lists did not trade because sellers’ reserves were not met.
Nearly $500mm of BB CLOs was available in November and nearly 85% of BBs traded.
Unfavorable conditions for CLO equity creation hampered new-issue CLO volumes even as spreads tightened
Even as spreads on CLO liabilities tightened in the new-issue market, CLO equity continued to be the bottleneck preventing the creation of CLOs. Simply put, the roughly 15 basis points of tightening in November did not increase the excess cash flow to CLO equity enough to make it a compelling investment. The only buyers of new-issue CLO equity continued to be CLO managers with the capital to purchase their own CLO equity [*4]. All other CLO managers could not justify the single-digit yields at which the new-issue market was creating CLO equity. BB tranches in the new-issue market continued to offer higher loss-adjusted yields than equities produced in the same CLOs.
According to Morgan Stanley’s CLO commentary, half of existing CLO warehouses have been around for over 9 months and they account for 70% of warehouse balances [*5]. In total, these warehouses add up to roughly $23 billion. Termed ‘hung’ warehouses, it is not possible to convert these warehouses into CLOs. Generally, warehouse documents require they expire after 9 to 12 months. As such, it is likely that many of these warehouses have reached or will soon reach maturity, and managers will have to decide whether to liquidate or extend these facilities. Since loan prices today are roughly 5 points below where they were 9 months ago, converting a warehouse into a CLO would require the buyer of equity to grossly overpay relative to the CLO equity available in the secondary market.
It remains to be seen what will actually happen with these warehouses if loan prices don’t rally significantly in the near future or if CLO liability spreads don’t contract significantly from current levels. Liquidation of warehouses is always a possibility when no other alternative can be found.
According to Citigroup, spread movements in November were as follows [*6]:
Footnotes:
[2] We defined credit tails as theoretical losses which would have been realized had CLO managers sold all loans trading below 85.
[3] For contrast, only about $225mm of CLO equity was available in October.
[4] While there may be some rare exceptions to this, we have not seen any compelling offers in new-issue CLO equity and have heard from dealers that they can only create CLOs when the CLO managers commits to all of the CLO equity.
[5] A CLO warehouse is typically an SPV into which a CLO manager buys loans prior to creation of the actual CLO. Once the CLO liabilities are priced, the loans in the CLO warehouse are transferred into another SPV that becomes the actual CLO.
[6] Information from Citigroup “2022-11-30 Citi Spreads.”
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