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  • Writer's pictureCapra Ibex

CLO Insider Newsletter: 2022 Year in Review

By Mike Kurinets, Chief Investment Officer


Key takeaways from December:

  • The leveraged loan market sold off slightly in December: Though the market reacted positively to November’s annual CPI number, which was the first 2022 CPI report that came in below expectations, the market’s reaction to the second unexpectedly low CPI print in December was subdued [1]. While most participants felt that inflation may have peaked, many felt that the economy was still headed towards a hard landing.

  • The loan market ended the year a full point above the YTD low: December’s loan market sell-off did not fully erase the gains made in October and November.

  • CLO liabilities tightened across the entire capital structure by about 15 basis points: Even so, CLO equity prices did not increase.

  • Challenging conditions for new-issue CLO equity arbitrage continued to suppress new-issue CLO volumes: Only $4.7 billion in new CLOs were issued in December, a value lower than January 2022 when CLO liabilities switched from LIBOR-based to SOFR-based [2]. Secondary market CLO equity continued to have more attractive excess cash flows than what was available in the new-issue market. In fact, new-issue CLO equity loss-adjusted yields were so unattractive that, at times, they were offered lower than those of BB tranches issued from the same CLO.

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


What had an impact on CLO markets in 2022 and what did not:

In 2020 and 2021, Covid-19 news drove market functioning. However, in 2022, other key forces emerged:

1. Inflation and fears of a hard landing affected CLO markets: Towards the end of 2021, there was a steady drumbeat of information and market discussion about inflation -- whether it was transitory, and whether it would precipitate a hard landing. However, early in 2022, concerns about inflation felt relatively mild, and at its first meeting in January, the Fed left rates unchanged [3].


2. The Fed’s response to inflationary pressures in 2022 affected CLO markets: Shortly after January’s Fed meeting [4], when the Fed left rates unchanged, the Fed’s mood shifted sharply. At each of the following seven Fed meetings in 2022, it raised rates for a cumulative rate hike of 4.25%. In nearly all of these meetings, the vote was unanimous in favor of higher rates [5].


In addition, the Fed announced programs to shrink its balance sheet [6] by allowing maturing securities to simply exit the market place [7]. Taken together with the rate hikes, the cumulative effect of 2022 Fed policy is comparable to increasing rates by 4.5% to 4.75%.

3. Though the war in Ukraine seemed like it would disrupt markets, it ultimately did NOT significantly affect CLO markets: After Russia invaded Ukraine in February 2022, there were concerns about a spike in energy and food prices [8]. These concerns temporarily contributed to market volatility, but in the end, the invasion did not have a significant impact on the US economy.


There were also fears that the parts of Europe that were significantly dependent on Russian oil and natural gas would experience severe economic contractions. While the US is not significantly impacted by direct trading with either Russia or Ukraine, there was concern that a contraction in Europe would have a significant impact on the US economy.

Ultimately, oil prices peaked shortly after the invasion of Ukraine [9] and ended 2022 lower than where they started. Energy prices did not significantly contribute to inflation or market turbulence in the US.


2022 trends in US$ CLO markets:

1. Leveraged loan prices dropped: 2022 was a volatile year for leveraged loan prices, and the down months saw significant price declines. Loan prices dropped well over two points in May, June, and September, when fears of ‘decades-high’ inflation were strongest. By the end of 2022, loan prices were nearly 6 points lower than at the start of the year. This affected the CLO market in two ways:

  • Lowered valuations of CLO equity: Not only were leveraged loans in CLOs valued lower, but with some loans trading down over 10 points [10], their yields implied increased likelihood of default in the near future [11]. As such, CLO equity with more time remaining in the reinvestment period significantly outperformed equities with time running out in the reinvestment period [12].

  • Widened spreads on CLO debt tranches: As the table below shows, spreads on all CLO debt tranches ended the year significantly wider [13]. The blended spread widening on CLO liabilities was 96 basis points.

Spread movements in 2022 on CLO debt tranches

2. CLO issuance significantly slowed in 2022: As leveraged loans sold off during the year and CLO debt tranche spreads widened, issuing new CLOs became increasingly uneconomic because the cash flows to CLO equity decreased.

Toward the end of 2022, the cash flows to new-issue CLO equity dropped so much that the BB tranches in new-issue CLOs were available at higher yields than the CLO equity. Stated differently, new-issue CLO equity became ‘rich’ to every part of the CLO capital structure in both the new-issue and in the secondary markets. Most, if not all, independent buyers of new-issue CLO equity disappeared. We believe that only CLO managers with ‘captive capital vehicles’ were able to issue CLOs during the second half of 2022.

We believe that the presence of ‘captive capital’ buyers is harmful to the CLO and leveraged loan markets because it interferes with the natural market forces that are needed for markets to correct during periods of volatility.

3. Resets and refinancing of CLOs nearly vanished in 2022: While there was limited activity in resets and refinancings during the first five months of the year, as CLO debt spreads widened, such actions completely stopped from June to December of 2022. During the last seven months of the year, not one CLO was reset or refinanced.


4. The transition from LIBOR to SOFR was very slow: From the start of 2022, all new issuance for loans and for CLOs had to be indexed to SOFR. The market expected that much of the loan market and subsequently much of the CLO market would transition from LIBOR to SOFR during 2022.

That did not happen. Market volatility and spread widening slowed down natural prepayments in loans because it became more expensive for loan issuers to refinance existing loans and replace them with new SOFR-based loans. As a result, by the end of 2022, nearly 80% of the leveraged loans in CLOs were still indexed to LIBOR.

All LIBOR contracts will have to convert from LIBOR to SOFR by the end of the second quarter of 2023. Therefore, we expect significant LIBOR to SOFR conversion activity to take place during the first half of 2023.


Footnotes:


[1] Loan prices did rise on the day that December’s CPI was announced, but fell within days due to concerns about a hard landing. On a relative basis, December’s CPI was lower than in previous months, but, as an absolute measure, CPI was still very high. As such, the Fed announced that more rate hikes would be needed to reduce inflation.

[2] Prior to December, January had been the slowest CLO issuance month of 2022.

[3] The Fed’s decision to leave rates unchanged in January was unanimous.

[4] January 27, 2022 was the Fed’s first meeting of the year.

[5] There was a single objection during the March and June meetings. All other rate hikes were unanimous.

[6] This is commonly referred to quantitative tightening.

[7] Capra Ibex’s proprietary analysis indicates that the cumulative effect of quantitative tightening is equivalent to a rate hike of 25 to 50 basis points.

[8] Ukraine exports sunflower oil, wheat, barley, corn, and various metals. According to the USDA, Ukraine is the world’s top producer of sunflower oil, a common and inexpensive cooking ingredient.

[9] According to Bloomberg data, price per barrel peaked on March 8, 2022 just below $124.

[10] The average price of a B- rated loan in 2022 was down 9.6 points.

[11] 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.

[12] Most CLOs have 5 years in their reinvestment periods at the time they are issued. CLOs with less than 12 months in their reinvestment periods significantly underperformed the ‘longer’ CLOs during the volatility of 2022.

[13] Data is sourced from Citi Velocity and mid-market spreads are shown for both the start and end of 2022.


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. Interests in Capra Credit Management, LLC (“Capra”) partnerships may not be purchased except pursuant to the partnership’s relevant subscription agreement and partnership agreement, each of which should be reviewed in its entirety prior to investment.

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