US CLOs could use a few bumps in the road
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US CLOs could use a few bumps in the road

Blurred Slot machines in a casino

Volatility in loans could get market functioning sustainably again

Last week was the first true post-pandemic SF Vegas as the conference finally took back its traditional (and much milder) February slot. It was certainly busier than last year too, with at least 8,000 delegates turning out. Yet while many attendees jetted to Nevada fresh off the heels of a successful opening to 2023, there was an air of caution about what lay ahead.

The apprehension was perhaps most notable amongst CLO market participants. Central bank liquidity and the low-rate environment it brought about had helped to pump out nearly 1,000 CLOs in 2021, but now the darlings of the pandemic years were beginning to get nervous.

To some extent, their apprehension seemed odd: over $20bn of supply has already been priced this year. However, GlobalCapital reported last week that some participants deemed the early deal rush little more than an unsustainable and illusory example of investors wanting to get back in the game after the holidays. A classic case of the January effect, they argued.

Back in September, a CLO manager had told GlobalCapital that if you can’t take the equity, you can’t make a CLO. Over six months on, it seems that this still holds true — with almost every new issue retaining the equity in 2023.

Indeed, with triple-C buckets in broadly syndicated US CLOs having steadily risen from around 4% in August to 5.5% in February, according to S&P, plus squeezed returns below the normal mid-teens, CLO equity is not looking attractive.

Somewhat unsurprisingly, therefore, some equity investors are heard to be trying to terminate CLOs as early as possible. This, in turn, is making managers less likely to consider selling their equity stakes.

Overall, it gives weight to the argument that the market is only half-functioning. There is an inescapable issue at hand: the arbitrage is not working.

CLO market participants like to highlight the product’s inherent resilience. They came through the global financial crisis and the pandemic unscathed, after all. But as interest rates tick higher (potentially for longer and at a faster rate following Federal Reserve chair Jerome Powell’s comments to Congress on Tuesday), another big test of that "resilient" tag is on its way.

Bank of America’s chief executive Brian Moynihan said a “slight” recession is likely in Q3 this week, while one economist at SF Vegas said a mild recession was inevitable. Broader market noises do not exactly give the impression that there is much to be hopeful about in the months ahead.

However, the pessimism brings to mind a comment one CLO trader made to this publication in January. In essence, he said that volatility and recessions — while not desirable — are the moments when market participants, be it traders or CLO managers, get the chance to show off.

With average leveraged loan prices seemingly stuck in the mid-90s, there is little managers can do to get around the fact that assets are too expensive for the elevated cost of CLO liabilities. In this sense, Moynihan’s “slight” recession might not be such a bad thing for a talented CLO manager — if it can cause a shake-up in leveraged loan prices. An eagle-eyed CLO manager would in this case have a chance to hunt for undervalued loan paper, and thus find a way to get the arbitrage equations working again.

Sure, in a bear market CLO spreads might also expected to widen. But a little volatility could suit nimble players, and yet again entice equity investors keen to gobble up a bargain. There's a chance that, in the medium term, this creates a more sustainably functioning CLO market where managers are not forced to retain equity.

If this does not happen, as reported last week, those smaller managers might find themselves gobbled up instead.

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