By Mike Kurinets, Chief Investment Officer
Key Takeaways:
Loan prices continued to rise in July. The price of leveraged loans increased by about 0.4 points in July after gaining 1.5 points in June. However, unlike in June, when loan prices rose on every trading day, by the middle of July the rally ended and prices gave back some ground.
CLO liabilities continued to tighten. On average, CLO liabilities tightened by 8 basis points in July, after tightening 16 basis points in June.
Inflationary pressures continued to ease. The CPI has been steadily declining. In July, the YoY CPI came in at 3.0%, lower than 4.0% in June and significantly below 9.1% a year ago [1].
After a pause in June, the Fed raised rates (by 25 bps) for the 11th, and possibly last, time. The market interpreted the decreasing inflation numbers as a sign that the Fed’s rate hikes were taking effect while the economy remained strong.
The market anticipated a smooth landing for the economy. The market believes that inflation, which hit a 40-year high a year ago, may have been tamed without any spike in unemployment.
ETFs continued to grow as a buyer of AAA CLO tranches.
The deadline on the LIBOR to SOFR transition passed without much fanfare.
The floating rate market transitioned smoothly from LIBOR to SOFR
The much anticipated deadline for transitioning the floating rate market from LIBOR to SOFR has passed. July was the first month when most loans and securities indexed to LIBOR had to be quoted in SOFR.
By the end of July, nearly every CLO had transitioned to SOFR plus the recommended adjustment of 26 basis points, as was widely expected. The transition in the loan market has been slower than in the CLO market. About 30% of the loan market continues to be quoted in LIBOR.
Overall, we don’t anticipate that the transition from LIBOR to SOFR will have a significant impact on CLO equity.
AAA CLO ETFs emerged as a growing buyer of CLO debt
As of July 2023, ETFs – which just 2 years ago did not purchase CLO tranches – now account for approximately $3.7 billion of AAA CLOs [2]. While that number pales in comparison to the roughly $700 billion of CLO AAAs outstanding, the growth of CLO ETFs suggests they may soon become a significant buyer of senior CLO tranches.
CLO investors adopted a risk-on approach Since the start of this summer, investors across the CLO capital structure have been adding risk. Most participants seemed to agree that despite 11 rate hikes, the US economy will experience a soft landing. This realization seemed to affect all credit markets, including the leveraged loan and CLO markets. By the end of July, CLO volumes were high and much of the paper was trading. Investors bid up all profiles of CLO equity, including shorter CLOs in which the remaining overcollateralization cushions had significantly deteriorated.
Spreads on CLO debt tranches have been compressing. Spreads have even compressed for lower quality junior mezzanine paper with little or no remaining subordination.
Risks remained for CLO investors
Even as demand grew, risks remained in the CLO market, such as:
An increase in the percentage of CCC rated loans: CLO managers have been able to mitigate the growth of CCC buckets simply by selling high-priced CCC loans and thereby reducing the amount of remaining CCC loans without losing par. However, if downgrades continue, CLO managers could run out of high-priced CCC loans to sell. In turn, it will be more difficult to manage rising CCC buckets without losing par, which would put pressure on OC cushions and could affect CLO equity and some junior mezz tranches.
Rising credit card and auto loan delinquencies: According to Moody’s, credit card delinquencies have now passed pre-Covid levels [3]. This demonstrates a burden on consumer spending, which accounts for nearly 70% of US GDP. While the unemployment rate in the US is at 3.5% [4], which is well below the long-term average of roughly 5.7%, it is worth monitoring such delinquencies and their potential impact on consumer behavior and the overall health of the US economy.
Distress in the commercial real estate space: About 10%, or $64 billion, of the commercial real estate securitized debt market is considered distressed. An additional $150bn in commercial real estate may also become distressed [5]. Smaller regional banks account for 32% of loans and investments in commercial real-estate [6]. A combination of higher interest rates and a potential spike in losses from exposure to commercial real estate could further limit bank lending capacity and adversely impact the growth of the US economy.
CLO liabilities continued to tighten in July
As loan prices continued to rise in July, spreads on CLO liabilities tightened across every part of the CLO capital structure.
July spread movements are below [7]:
CLO Tranche Rating | June Spread Change (bps) | July Spread Change (bps) | Spreads July 2023 (bps) |
AAA | -15 | -7 | 186 |
AA | -27 | -10 | 234 |
A | -25 | -10 | 301 |
BBB | -35 | -20 | 521 |
BB | -5 | -15 | 966 |
Footnotes:
[2] Morgan Stanley Leveraged Loan and CLO Commentary. August 4, 2023.
[3] https://www.moodys.com/research/Banks-US-Q2-2023-household-debt-and-credit-update-New--PBC_1377634
[7] Spreads from CitiVelocity.
Forward Looking Statements:
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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.