By Mike Kurinets, Chief Investment Officer
Banking Crisis Rattles CLO Market
Before diving into our commentary about the CLO and leveraged loan markets in February, we wanted to touch on how the markets have reacted to the events of the past two weeks.
After an uneventful start to March, the news that both Silicon Valley Bank and Signature Bank had entered FDIC receivership – as well as the ensuing deposit withdrawals from other regional banks and fears of a national bank crisis like in 2008 – sent all markets, including the leveraged loan and CLO markets, into turmoil.
In just over a week, loan prices dropped nearly 1.6 points and CLO liabilities noticeably widened. The weighted average cost of CLO liabilities widened by 43 basis points.
CLO Tranche Rating | March 21, 2023 (bps) | February 28, 2023 (bps) | March Spread Widening |
AAA | 208 | 167 | 41 |
AA | 275 | 225 | 50 |
A | 385 | 335 | 50 |
BBB | 580 | 535 | 45 |
BB | 1000 | 948 | 52 |
In the face of rate hikes and market volatility, CLO AAAs have preserved their value better than other AAA-rated securities
Because nearly all CLO debt tranches are floating-rate, CLO AAAs have not seen significant price movement amid the 2022 rate hikes and recent banking crisis. Most CLO AAA tranches continue to trade in the mid-90s and higher, and have preserved their value far better than longer-dated fixed-rate US Treasuries, Agencies, and CMBS bonds.
February Brought Higher CLO Equity Prices and Wider Debt Spreads
Key Takeaways from February:
The leveraged loan market hardly moved in February: After the 8th rate hike on February 1, the loan market rallied for about a week and prices rose 0.5 points. However, after the month-over-month CPI number came in high at 0.5 points, the loan market’s gains reversed, and the market ended February slightly down.
CLO liabilities widened across the entire capital structure by about 12 basis points.
New-issuance volumes rose while conditions for CLO creation remained challenging: With CLO spreads wider in February than they were in January and loan prices essentially unchanged, excess cash flow to CLO equity did not improve.
Battle in transitioning loans from Libor to Sofr continued: Private equity sponsors continued to push dealers to send out loan amendments with a determination that the ‘market standard’ for loans to transition from Libor to Sofr was 10 basis points. CLO investors and CLO managers continued rejecting that determination in favor of the previously set CSA ladder [1].
There was no reset or refinancing activity in February: Resets and refinances have been very low since last March and there were no resets or refinancings during the second half of 2022.
CLO equity prices rose slightly in February as credit tails declined
The prices of all CLO equity profiles increased slightly in February because credit tails in most CLO portfolios decreased. Even though leveraged loan prices did not move meaningfully during the month, loan prices in the low-to-mid 80s rose slightly, so that the loans that showed up in credit-risky buckets in January came out of those buckets in February. As a result, CLO equity modeled to higher yields in February than it did in January.
CLO spreads widened after the high month-over-month CPI print
Although the annual CPI number continued to decrease in February, the monthly number, at 0.5 points, caused concern that the Fed would continue to raise rates and that it would be less likely to cut rates in 2023. Concerns that continued rate hikes could result in unintended consequences, such as a recession, caused assets to price to higher yields.
CLO Tranche Rating | February 20, 2023 (bps) | January 31, 2023 (bps) | Spread Widening in February |
AAA | 167 | 160 | 7 |
AA | 225 | 215 | 10 |
A | 335 | 320 | 15 |
BBB | 535 | 493 | 42 |
BB | 948 | 888 | 60 |
Many leveraged loan issuers continued to try to reduce Credit Spread Adjustments (“CSAs”)
By the end of Q2:2023, all existing contracts referencing Libor will switch over to Sofr [2]. In our January letter, we addressed the conflict between CLO equity investors and loan issuers regarding off-market CSAs in significant detail. In February, while private equity sponsors continued to pressure dealers to send out loan amendment letters with 10 basis point CSAs, investors in CLO equity effectively banded together to successfully reject such amendments.
As a quick reminder, the CSAs at which all Libor contracts should transition to Sofr is well known [3]. Recommended spreads for the transition from Libor to Sofr are below:
From Libor to Sofr | AARC recommended CSA (bps) |
1m Libor to 1m Sofr | 11.4 |
3m Libor to 3m Sofr | 26.2 |
6m Libor to 6m Sofr | 42.8 |
Footnotes:
[1] The CSA ladder was set to 11 basis points for loans that reset monthly and 26 basis points for loans that reset quarterly.
[2] This will include both leveraged loans and CLO liabilities.
[3] CSAs were recommended by the ARRC on March 5, 2021. ARRC stands for the Alternative Reference Rates Committee, which is convened by the Federal Reserve Bank.
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