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  • Writer's pictureCapra Ibex

CLO Insider January 2023: What Didn't Change When the Market Rallied

By Mike Kurinets, Chief Investment Officer


Key takeaways from January:

  • The leveraged loan market rose sharply in January: For most of 2022, the leveraged loan market sold off in response to high inflation and Fed rate hikes. In January, the third consecutive low year-over-year CPI print (which came in at 6.5% for December) set the market up for a strong rally.

  • By the end of January, the loan market was up over 1.7 points: The last month that saw an increase of over 1.7 points in the leveraged loan market was November 2020, when Covid-19 vaccines that were over 95% effective were announced and the markets began to see a path to ending the Covid pandemic.

  • CLO liabilities tightened across the entire capital structure by over 30 basis points: AAA, AA, A, and BBB tranches all tightened by approximately 25-40 basis points, while BB tranches tightened by about 75 basis points.

  • Despite the strong rally in leveraged loans, conditions for CLO issuance remained challenging: CLO issuance volumes remained low because CLO equity arbitrage [1] continued to be challenging.

  • Loan issuers, many of which are owned by Private Equity firms, have been trying to transition loans from Libor to Sofr at off-market spreads: This is harmful to investors in CLO equity and we are actively preventing this activity.

  • There was no reset or refinancing activity in January: Resets and refinances have been very low since March and there were no resets or refinancings during the second half of 2022.

January's Rally Brings Higher CLO Equity Prices and Tighter Debt Spreads


January’s Rally Increased CLO Equity Prices

The prices of all CLO equity profiles increased in January, as the leveraged loan market rallied 1.7 points for the month in response to the third consecutive low year-over-year CPI report. CLO equities that are considered 'long' [2] and have below average credit tails saw a particularly strong rally [3]. This is not typical during a sharp rally in leveraged loan prices.

More often, during sharp rallies in loan prices, shorter CLO equities, which derive the bulk of their value from principal [4], see larger percentage upswings. However, while loan prices rose significantly in January, credit tails did not decrease meaningfully. Therefore, the CLO collateral pools continued to imply that there might be significant losses in the future. This concern about persistently large credit tails tempered the rise in prices of shorter CLO equities even though, on average, loan prices rose sharply.


January’s Rally Tightened CLO Debt Spreads

The weighted average spread tightening across the CLO capital structure was 32 basis points in January. This is a highly significant spread tightening for a single month and reflects the significant rally in the prices of leveraged loans. CLO debt spread movements in January were as follows [5]:

CLO debt spread movements in January

Even with Tighter CLO Capital Structure, New-Issue CLO Equity Remained Unattractive

New-issue CLO equity continued to be unattractive for third party investors in January. CLO managers or captive-capital vehicles continued to be the main buyers of CLO equity in the new-issue market.

While new-issue equity did look more attractive at the end of January than it did at the end of December, it remained significantly less attractive than both CLO equity in the secondary market and BBs in the new-issue market. January's buyers of new-issue CLO equity appeared to be motivated by reasons other than maximization of returns.

After the strong rally in loan prices, CLO equity could no longer be offered at significant discounts to par. In other words, CLO managers had to sell new-issue CLO equity at higher prices [6] in order to buy loans into CLO collateral pools.

In previous months, when leveraged loan prices were significantly lower, new-issue CLO equity could be created at lower prices. However, the higher spreads on CLO debt left very little excess cash flow to CLO equity. Today, the excess cash flow is bigger but equity must also be sold at higher prices. CLO arbitrage does not work and will not work until CLO liabilities tighten significantly from current levels. We estimate that, all else being equal, roughly another 40 to 50 basis points in tightening on CLO liabilities will be needed before new-issue CLO equity becomes an attractive investment [7].


Libor-Sofr Transition Sparks Conflict Over Off-Market Credit Spread Adjustments


As Contracts Transition from Libor to Sofr, Some Leveraged Loan Issuers Have Attempted to Reduce Credit Spread Adjustments

By the end of Q2:2023, all existing contracts referencing Libor will switch over to Sofr [8]. That is a hard deadline.

The Credit Spread Adjustment (“CSA”) at which all Libor contracts should transition to Sofr is well known [9]. Recommended spreads for the transition from Libor to Sofr are below:

From Libor to Sofr

ARRC recommended CSA (basis points)

1m Libor to 1m Sofr

11.4

3m Libor to 3m Sofr

26.2

6m Libor to 6m Sofr

42.8

All contracts issued since the start of 2022 have automatically referenced Sofr [10]. However, very few pre-existing loans transitioned because 2022 was too volatile. Loan prices dropped roughly 5.9 points last year and loan refinancing activity slowed sharply. As a result, with five months remaining, over 80% of the loan market has yet to transition from Libor to Sofr.


Many issuers of leveraged loans have been actively trying to transition from Libor to Sofr at spreads lower than the recommended spreads. In fact, there have been some amendments done without any spread adjustment at all. There are a number of reasons why this is happening:

  • Negative Covenants: Many loan amendments have negative covenants. This means that unless a majority of loan holders actively object to the proposed amendment within a short period of time [11], the amendment will pass with lower, or even zero, adjustment spread.

  • Borrowers are Intentionally Making it Difficult to Object to Off-Market Amendments:

    • Many loan holders [12] have noted that they didn’t have time to object because amendments were either sent out late on a Friday afternoon or immediately before a holiday weekend.

    • Some loan amendments have been sent without a contact with whom to register an objection.

    • Other loan amendments had inserted an extra step by requiring that the objection first must be registered with a banking agent who would in turn register the objection with the borrower.

    • Finally, banking agents for some amendments have determined that, regardless of the recommended spreads, the market standard is lower [13].

In contrast, most market participants [14] believe that all CLO liabilities will transition from Libor to Sofr at the recommended spreads because many CLOs will automatically trigger conversion from Libor to Sofr when over 50% of the loans in the CLO become Sofr based.


CLO Equity Investors Have Organized to Object to Off-Market Loan Amendments

If all CLO liabilities transition from Libor to Sofr at the recommended spreads but leveraged loans transition at spreads lower than recommended, the effect will be lower cash flows to CLO equity. This would make CLO equity less valuable.

Therefore, CLO equity investors have organized and formed a working group to immediately notify each other of any off-market loan amendment that is being pushed through.

At Capra, we immediately found all CLOs in which we own equity and notified our CLO managers that we expect them to object to any off-market proposal. We are pleased to say that as a result of our action and those of likeminded equity investors, many off-market loan amendments, though not all, have been denied.

To draw more attention to this issue, Capra has recently been interviewed by the press. Please see our comments in the Wall Street Journal and Bloomberg for more detail on the tactics of loan issuers attempting to transition loans at off-market spreads.


Footnotes:


[1] CLO equity arbitrage is a term that market participants often use to describe the magnitude of cash flow to the CLO equity tranche. When CLO equity arbitrage conditions are challenging, the cash flow to the equity is low and independent third party investors in CLO equity find new-issue CLO equity un-investable. Most, if not all, new-issue equity continues to be taken down by CLO managers.

[2] Long CLO equity generally means equities of CLOs that have over 2.5 years remaining in their reinvestment periods.

[3] At Capra, we view loans trading below 85 as credit-risky and assume a higher default probability on them when valuing CLO equity and CLO debt tranches. We refer to these loans as ‘credit tails’ in the CLO collateral.

[4] Since much of their cash flows have already been received during previous payment periods.

[5] Mid-market spreads according to CitiVELOCITY.

[6] Many new-issue CLO equities we see are offered in the very high 80s or low 90s.

[7] This assumes that CLO managers will not raise their management fees and that prices of leveraged loans do not significantly rise from current levels.

[8] This will include both leveraged loans and CLO liabilities.

[9] CSAs were recommended by ARRC on March 5, 2021. ARRC stands for Alternative Reference Rates Committee which is convened by the Federal Reserve Bank.

[10] The last contracts referencing Libor were issued at the end of 2021.

[11] Investors typically have only 5 days to respond with an objection to a negative covenant.

[12] Most of the loan holders are CLO managers.

[13] Many loan amendments have been passed with a spread adjustment of only 10 basis points.

[14] At Capra, we have polled many of the CLO managers whose equity we hold. They all agree that for CLO liabilities, the market will follow CSAs recommended by ARRC.


Forward Looking Statements:

Some of the statements contained in this presentation constitute forward-looking statements within the meaning of the federal securities laws. Forward-looking statements relate to expectations, beliefs, projections, future plans and strategies, anticipated events or trends and similar expressions concerning matters that are not historical facts. In some cases, you can identify forward-looking statements by the use of forward-looking terminology such as “may,” “will,” “should,” “expects,” “intends,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” or “potential” or the negative of these words and phrases or similar words or phrases which are predictions of or indicate future events or trends and which do not relate solely to historical matters. You can also identify forward-looking statements by discussions of strategy, plans or intentions. The forward-looking statements contained in this presentation reflect our current views about future events and are subject to numerous known and unknown risks, uncertainties, assumptions and changes in circumstances, many of which are beyond our control, that may cause our actual results to differ significantly from those expressed in any forward-looking statement. Statements regarding the following subjects, among others, may be forward-looking: the use of proceeds from our public and private offerings (as the case may be); our business and investment strategy; our projected operating results; our ability to obtain financing arrangements; financing and advance rates for our target assets; our expected leverage; general volatility of the securities markets in which we invest; our expected investments; effects of hedging instruments on our target assets; rates of leasing and occupancy rates on our target assets; the degree to which our hedging strategies may or may not protect us from interest rate volatility; liquidity of our target assets; impact of changes in governmental regulations, tax law and rates, and similar matters; availability of investment opportunities; availability of qualified personnel; estimates relating to our ability to make distributions; our understanding of our competition; and market trends in our industry, interest rates, real estate values, the debt securities markets or the general economy. While forward-looking statements reflect our good faith beliefs, assumptions and expectations, they are not guarantees of future performance. Furthermore, we disclaim any obligation to publicly update or revise any forward-looking statement to reflect changes in underlying assumptions or factors, new information, data or methods, future events or other changes. This presentation contains statistics and other data that has been obtained from or compiled from information made available by third-party service providers. We have not independently verified such statistics or data.

Disclaimers:

This confidential document is for informational purposes only and does not constitute an offer to sell or a solicitation of an offer to buy any securities or partnership interests described herein.


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