CLO Insider August 2022: The Market Rally's Reversal
by Mike Kurinets, Chief Investment Officer.
In this month’s CLO Insider, we explore how the CLO and leveraged loan markets reacted to Jerome Powell’s indication that the Fed would likely continue to hike rates aggressively. Powell’s hawkish speech at the Jackson Hole Economic Symposium sobered the markets, halting the relief rally that occurred in July and early August. In the wake of his comments, the markets adjusted to the idea that an economic slowdown may be inevitable.
After increasing 1.7 points from the start of August to mid-August, leveraged loan prices started to decline on the back of Powell’s comments. Loan prices closed the month just 1 point higher than at the start of the month.
Similarly, CLO investors seemed to gravitate towards CLO equities with more time remaining in the reinvestment period. This market preference indicates a concern that the U.S. economy is not out of the woods yet. In addition, despite the increase in loan prices – which made CLO collateral more expensive – spreads on CLO liabilities did not tighten. These dynamics made it difficult to originate new-issue CLOs
Market Rally Reversed After Powell's Hawkish Tone at Jackson Hole
July’s rally persisted through mid-August
Last month’s newsletter described how the market rallied in July after a significant selloff in May and June, even though inflation indicators remained high and the Fed’s fourth rate hike brought the cumulative rate increase this year to 2.25% [*1]. The market rally continued through mid-August, despite another high CPI print, and the market seemed to view its significant selloff in May and June as an overreaction. During the second half of August, as the annual end-of-summer economic summit in Jackson Hole neared, the relief rally ended. At the summit, Jerome Powell signaled that the Fed would likely need to adopt additional large rate hikes to control inflation. The market immediately repriced assets lower to reflect the reality that the Fed will continue to act aggressively to stem inflation and that, therefore, an economic slowdown may be unavoidable. As part of this market adjustment, leveraged loans and CLOs traded at lower prices. By the end of August, loan prices had increased 1 point from the start of the month. However, during the middle of the month, prices had been up by 1.7 points.
Investor preference leaned towards longer-dated CLO equities
While all CLO equities traded well for most of August, most of the investor appetite focused on CLO equities which have over three years remaining in their reinvestment periods (rather than on shorter CLO equities which have less than one year remaining in their reinvestment periods). This preference towards longer CLO equities indicates that, despite the recovery that occurred from the middle of July through the middle of August, many market participants remained concerned that the U.S. economy had not yet turned a corner and that significant issues may still arise in the near future.
New-issue CLOs struggled to print as loan prices increased but CLO liability spreads did not tighten
Though prices in the leveraged loan market ended the month one point higher, spreads on CLO liabilities did not tighten. As a result, new-issue CLO origination struggled because managers had to purchase loans at higher prices while the cost of CLO debt did not decrease. This combination of market forces raised the prices at which new-issue CLO equity could be created, while cash flows to CLO equity would not increase.
There was no reset or refinancing activity in August.
According to Morgan Stanley, spread movements in August were as follows [*2]:
[*1] The Fed raised rates by 25 bps in March, 50 bps in May and 75 bps in both June and July.
[*2] Information from Morgan Stanley CLO Trading Desk, in “Morgan Stanley CLO Commentary” released July 29, 2022.
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