by Mike Kurinets, Chief Investment Officer.
In this month’s CLO Insider, we explore the sell-off in the CLO and leveraged loan markets that started at the end of August and persisted through September. Driven by concerning economic indicators (including an unexpectedly high CPI report and a Fed Funds prediction that exceeded market forecasts), loan prices continued to decline throughout the month.
As a result, the CLO market showed signs of stress. CLO equity trading effectively stopped during the second half of the month, and CLO BB bid lists saw both motivated sellers and shallower bids. Surprisingly, new-issue CLO volumes increased, even though widening spreads on liabilities meant that cash flow to equity would decline.
Leveraged Loan and CLO Markets Sold Off in September
Markets Struggled to Find a Reason to Rally in September
At the end of August, after Jerome Powell’s hawkish tone at the Jackson Hole Economic Symposium startled the market, leveraged loan prices declined. For the first week of September, loan prices continued to drop. However, in the days leading up to the September CPI announcement, the market rallied. Investors hoped that the CPI number would finally demonstrate the efficacy of this year’s four rate hikes. Nevertheless, the CPI release disappointed the market. The year-over-year CPI in September was 8.2, higher than the anticipated 8.1. In response to the CPI announcement, leveraged loan and CLO prices fell.
For the rest of September, negative news continued to concern the market. A few days after the CPI came out, the CEO of FedEx forecasted a global recession based on a significant drop in shipping. Additionally, when the Fed proceeded with its widely expected 75 bp rate hike [*1], the Fed’s Dot Plot [*2] showed that members anticipated that, by the end of the year, rates would be significantly higher than the market consensus suggested. Events in Europe, the United States' biggest trading partner, also stoked the market’s fears. Russia’s announcement of a partial draft signaled that the war would worsen and, therefore, that exports of commodities such as iron, sunflower oil, corn, and wheat would remain restricted. Furthermore, the Nord Stream pipeline explosions imposed another limitation on Russian gas delivered to Europe. On top of developments in the war, the Bank of England had to intervene to stabilize the UK bond market by purchasing UK government bonds [*3].
We Didn’t See Panic, But Noticed Signs of Stress in the CLO Market
The CLO market seemed much more stressed during the second half of the month.
Indications of stress included:
CLO equity trading essentially stopped during the second half of September.
While CLO BBs traded throughout the month, there often were multiple bid lists per day for CLO BBs and lists were frequently scheduled 30 minutes apart. This generally occurs when a seller is motivated to sell even though other bid lists have already been announced. As such, the seller schedules his or her list between those already announced [*4].
Less market color was released. Often when a BB CLO list would trade, the only data released to the market was that a trade took place, but not the level at which the BB CLO traded or covered.
We felt that there was greater price tiering differentiating top quality BBs and lower quality BBs.
Dealers told us that the depth on bid lists decreased. While there was a narrow range among the top two or three bids, bids four or five became further distanced from the top bids during the month.
New-Issue CLO Volumes Increased Despite Unfavorable Conditions
When CLO liabilities widen by nearly 35 basis points in a single month, as they did in September, it would be reasonable to anticipate that new-issue volumes should decrease since cash flow to CLO equity would decline by approximately 3 points per annum [5]. We believe such widening in CLO liabilities should reduce the value of new-issue CLO equity by roughly 12 to 15 points [*6].
In theory, the new-issue volumes seen in September with decreased equity cash flows would be possible if the collateral had been purchased at the lower dollar price seen in the September market. However, much of the collateral for new-issue CLOs was purchased before the September sell off in loans (at higher prices). Therefore, we believe the only way a new-issue CLO could be created at their current prices would be if a ‘yield insensitive’ buyer stepped in.
We believe that captive capital (also known as ‘committed capital’) enables the continued issuance of new CLOs at the expense of reduced returns to the buyer of CLO equity in the new-issue market. Recently, we’ve even seen cases in which loss-adjusted yields on CLO equity are lower than those of BBs from the same CLO.
According to Morgan Stanley, spread movements in September were as follows [7]:
Footnotes:
[*1] This was the fifth hike of the year for a cumulative increase of 300 basis points.
[*2] The Dot Plot records each member of the Fed’s individual projection for the Fed Funds rate, with each dot representing one Fed official.
[*3] UK government bonds are called gilts.
[*4] This behavior is less common during stable markets. In stable markets, if a new seller decided to sell after other Bid Lists have been announced, he or she would simply wait until the next day.
[*5] While it is true that the fifth Fed rate hike of the year (which was 75 basis points in September) increases net cash flow to CLO equity, this increase is more than offset by the 35 basis points widening in CLO liabilities. 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.
[*6] The duration of new-issue CLO equity is roughly 4 years. 3 points per year * 4 years duration = roughly 12 points in value.
[*7] Information from Morgan Stanley CLO Trading Desk, in “Morgan Stanley CLO Commentary” released September 30, 2022.
Forward Looking Statements
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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.