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Gravity-defying US CLO mart struggling to continue

New York-New York Hotel & Casino in Las Vegas, Nevada, United States of America, USA

Fast start to 2023 can’t last for long, say SF Vegas delegates

The second quarter of 2023 will be much more difficult for new US CLO creation as arbitrage challenges, further rate rises and a lack of investors will begin to bite, delegates and speakers at SF Vegas told GlobalCapital.

Some $13.6bn of new issues in February continued a strong start to the year, taking the overall total for the year above $20bn and making it the best month for issuance since April 2022.

Nevertheless, a CLO equity investor at the conference said the arbitrage equation further down the capital stack remained “squeezed”. He said for this to change either triple-A spreads had to tighten with asset prices staying the same, or spreads had to stay with asset prices getting cheaper.

However, there seems little hope of that materialising. Panellists at SF Vegas said triple-A spreads looked “cheap” relative to other structured products, even though spreads have tightened sharply since October where a 220bp print was commonplace. Indeed, CIFC Asset Management priced its Texas Debt Capital CLO on Wednesday with the triple-As at 180bp over Sofr.

Further tightening appears unlikely, Edwin Wilches, co-head of securitized products at PGIM, said while on a panel. In 2021, banks were “indiscriminately” investing in CLOs, taking up around $55bn (or 75%) of the triple-A market, he said.

However, since those traditional senior note buyers stepped away from the market once 2022 became much more volatile, it is hard to see any further tightening, he added.

“I don’t expect them to come back, and I think all that means is although triple-As look really attractive, longer term... it also means that missing a trade here and there isn't that big because there’s so much supply coming,” Wilches said.

Fellow panellist Kashyap Arora, co-CIO of Vibrant Capital Partners agreed, saying there were only a “handful” of investors in that market with many dependable investors “missing from the market right now”.

Defying gravity

So far in Q1, the US CLO market has looked as though it’s getting back to normal following a challenging 2022. However, in every new issue this month, the CLO manager retained the equity, according to data from Finsight.

This, a CLO banker told GlobalCapital, revealed something of an illusory effect in the market.

For much of the past 12 months, CLO new issues have only been possible with the manager buying the equity but most of those managers cannot do that forever, because arranging banks would no longer feel comfortable lending the initial capital.

If a smaller manager constructs three or four CLOs in this way, it is likely to find itself forced to sell its business to a larger rival, if arbitrage challenges remained as they are, he added.

The banker said that “almost every” CLO manager outside of the top 30 was up for sale, with vast “consolidation” expected in the coming months.

As a result, while CLO debt investors might sense that spreads are attractive, they run the risk of facing unwelcome call options by new managers, eating into their total returns.

Once the new owner takes on a CLO fund, if the existing manager also controls the equity, they are free to call the transaction when they choose (once out of the non-call period). Whether it benefits the CLO debt investors may not be the same concern to the new owners as it was the old CLO manager.

“Those in control will exercise it,” the banker said.

Away from the market dynamics, there are also broader fears of a US recession leading to a higher proportion of downgrades in CLOs as well.

MUFG’s US economic outlook says a recession remains the most likely outcome in the next 12 months, with positive sentiment in wider structured product markets “likely just another bear trap”.

Meanwhile, a ratings analyst told GlobalCapital downgrades were “inevitable” while triple-C buckets in CLOs could get up to and above 7.5%. Research from S&P said that at the start of February, it had already reached 5.5% from a low of 4% in August 2022.

Geoff Horton, CLO portfolio manager at BlackRock told delegates at the conference it could pay to be “defensive” in the next few months.

“I’m a bit more focused and worried about the triple-Cs and what a manger is going to do about those,” he said. “They tend to spike pretty quickly and come down in a fairly quick-ish manner.”

“But say interest rates stay at 6% or above for two, three, four years? We haven’t seen that environment for quite some time.”