By Mike Kurinets, Chief Investment Officer.
In this month’s CLO Insider, we explore the signs of relief that the CLO and leveraged loan markets saw in October. Early in the month, the leveraged loan market rallied, indicating that participants viewed September’s dramatic sell-off as an overreaction. The rally faded towards the middle of the month as the CPI release approached. Though the 8.2% CPI number [1] was still high, it seemed to show that rate hikes were beginning to reduce inflation. By the end of October, loan prices had risen by 0.3 points.
In the CLO markets, we saw liabilities continue to widen in October. Unlike in September, October new-issue CLO volumes declined, appearing to adjust to the challenging conditions available for CLO equity arbitrage.
October Brought Signs of Relief to the CLO Market
Markets Saw Glimmer of Hope in October, But Did Not Rally Dramatically
During the first few days of October, there seemed to be a ‘relief rally’ in the leveraged loan market. Market participants apparently felt that September’s dramatic sell-off had been an overreaction. Leveraged loan prices increased by 0.64 points during the first four days of the month. During one of the days of this rally, leveraged loan prices rose by 0.55 points. The last time loan prices saw a greater increase in a single day was on November 9, 2020 -- the day Pfizer announced that it had developed a vaccine that was 90% effective in fighting Covid.
Nevertheless, that feeling of relief dissipated by the middle of the month as the CPI release approached. The CPI number offered a mixed message to the market. On the one hand, the 8.2% Year-Over-Year CPI that came out in October still demonstrated that inflation remained very high. On the other hand, since the CPI was lower than the previous month’s, it signaled that the cumulative effect of rate hikes was finally beginning to reduce inflation. While the leveraged loan market oscillated without much conviction, most market participants seemed to accept that inflation may have peaked. At the same time, they also realized that the Fed would still need to continue raising rates to significantly lower inflation.
Unlike in September, we did not see a steady stream of bad news in October. By the end of the month, the general sentiment seemed to acknowledge that, while there is still a long way to go in managing inflation, there is a proverbial light at the end of the tunnel.
Though Loan Prices Rose, Prices of CLO Junior Debt Did Not Increase
While loan prices were about 0.3 points higher in October, the number of stressed loans continued to grow. Credit tails [*2] in CLO portfolios continued to rise, though at a far slower pace than in September. As a result of higher theoretical losses on CLO collateral pools, the prices of tranches at the bottom of the capital structure, such as CLO equity and BBs, did not increase in October.
In addition, Norinchukin Bank, a large Japanese buyer of AAA CLOs, announced that it would be pausing all purchases of CLO AAAs for the foreseeable future. Though Norinchukin clarified that the pause is not a permanent exit, the pull-out of a large buyer may have caused additional spread widening in CLO AAAs [*3].
CLO Equity Trading Volumes Rose in the Second Half of October, and BBs Traded Throughout the Month
After the leveraged loan markets sold off during the second half of September, CLO trading volumes slowed down and remained low during the first half of October. Because the leveraged loan market rally was widely perceived to be a ‘relief rally,’ it did not inspire CLO buyers to come off the sidelines. As a result, only 51mm of CLO equity appeared on bid lists during the first half of October. After the CPI release, CLO equity volumes increased. Some 186mm of CLO equity appeared on bid lists in the second half of October, however prices of CLO equity did not rise.
BB CLOs continued to trade throughout the month. Over 200mm of BB CLOs appeared on bid lists during the first half of October, and over 450mm appeared on bid lists during the second half of the month.
CLO Equity Trading Volumes Rose in the Second Half of October, and BBs Traded Throughout the Month
After the leveraged loan markets sold off during the second half of September, CLO trading volumes slowed down and remained low during the first half of October. Because the leveraged loan market rally was widely perceived to be a ‘relief rally,’ it did not inspire CLO buyers to come off the sidelines. As a result, only 51mm of CLO equity appeared on bid lists during the first half of October. After the CPI release, CLO equity volumes increased. Some 186mm of CLO equity appeared on bid lists in the second half of October, however prices of CLO equity did not rise.
BB CLOs continued to trade throughout the month. Over 200mm of BB CLOs appeared on bid lists during the first half of October, and over 450mm appeared on bid lists during the second half of the month.
New-Issue CLO Volumes Declined as Conditions Remained Unfavorable for CLO Equity Creation
We believe that the widening on CLO liabilities by about 35 basis points in September, and then by an additional 13 basis points in October, should decrease the volumes of new CLOs issued. All else being equal, September's widening would cause cash flow to decline by approximately 3 points per annum and October's widening would cause cash flow to decline by about 1.2 points per annum [*4]. Given the reduced expected cash flow, we believe such widening in CLO liabilities should, in theory, reduce the prices of new-issue CLO equity by roughly 12 to 15 points in September and by an additional 3 to 5 points in October [*5]. But that cannot happen in practice because at such low prices, there would not be enough money to purchase the CLO collateral and issue the new CLO.
In September’s letter we discussed how we could only explain the continued issuance of new CLOs by assuming that the buyer of new-issue CLO equity must be insensitive to yields. For example, an investor who has committed capital to a CLO manager for the purpose of buying CLO equity issued by that CLO manager would witness his or her capital being deployed at yields that are lower than comparable investment opportunities. At Capra, we have seen new-issue CLO equity offered at yields that were lower than loss-adjusted yields for BB tranches of the same CLOs.
As we see it, this misalignment of interest between some CLO managers and their captive capital investors caught up to reality in October. New issue volumes dropped in October, with just $8.7 billion in new CLOs issued.
According to Citigroup, spread movements in October were as follows [*6]:
Footnotes:
[*1] https://www.bls.gov/news.release/archives/cpi_10132022.htm
[*2] We refer to credit tails as losses on CLO collateral pools that would theoretically be realized if all loans trading below $85 were to be sold at their market values.
[*3] It is worth noting that when Norinchukin Bank last pulled out of the CLO market (from March to July of 2019) spreads on CLO AAA tranches actually contracted.
[*4] While it is true that the fifth Fed rate hike of the year (which was 75 basis points in September) increased net cash flow to CLO equity, this increase is more than offset by the 48 basis points widening in CLO liabilities that occurred in September and October.
To calculate the impact of the 35 bp widening in September: Assuming that a hypothetical CLO will have $100 of collateral, $90 of debt, and $10 of equity, the additional cash flow to CLO equity from the rate hike would be: (75 basis point rate hike on $100 of collateral) - (75 basis points on $90 of CLO debt) = 0.75 points per year of additional cash flow to CLO equity. However, the impact of liability spreads widening would be (0.0 basis points widening in stated spread on loans) - (35 basis points widening on $90 of CLO debt) = 0.32 points per year of reduced cash flow on collateral. Since equity is 10x levered, new-issue equity now has 3.2 points less in cash flow compared to secondary CLO equity. To calculate the impact of the 13 bp widening in October: Assuming that a hypothetical CLO will have $100 of collateral, $90 of debt, and $10 of equity, the additional cash flow to CLO equity from the rate hike would be: (75 basis point rate hike on $100 of collateral) - (75 basis points on $90 of CLO debt) = 0.75 points per year of additional cash flow to CLO equity. However, the impact of liability spreads widening would be (0.0 basis points widening in stated spread on loans) - (13 basis points widening on $90 of CLO debt) = 0.12 points per year of reduced cash flow on collateral. Since equity is 10x levered, new-issue equity now has 1.2 points less in cash flow compared to secondary CLO equity.
[*5] The duration of new-issue CLO equity is roughly 4 years. For September’s widening, 3 points per year * 4 years duration = roughly 12 points in value. For October’s widening, 1 point a year * 4 years duration = roughly 4 points in value.
[*6] Information from Citigroup Global Markets, in “2022-10-31 Citi Spreads.”
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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.