CLOs: Supply/Demand Dynamics Driving Opportunities
The positive sentiment that characterized the first half of this year waned somewhat in the third quarter amid the spreading Delta variant and uncertainty around China’s economic growth picture. Nonetheless, the collateralized loan obligation (CLO) market saw positive performance, supported by optimism around vaccination rates and the continued economic recovery. Overall, AAA, AA and single-A tranches returned 0.33%, 0.51% and 0.68%, respectively. BBB, BB and single-B tranches also delivered positive returns, at 0.89%, 1.89% and 4.13%.1
Similar to what we saw in the first and second quarters, CLO issuance surged through September, reaching $45.9 billion in the U.S. and €11.4 billion in Europe. This is partly because the expected supply lull in August never came—with U.S. new issuance reaching a record-breaking $18.5 billion for the month. But once again, new issuance was only part of the story. Indeed, ahead of the October quarterly payment date, refinancing and reset issuance picked up significantly in September, as a number of 2019 and 2020 vintage deals reached the end of their non-call periods, and CLO equity holders looked to take advantage of a lower cost of capital. Accordingly, total quarterly issuance—including refinancing and reset transactions—reached nearly $100 billion in the U.S. and just over €20 billion in Europe.2
FIGURE 1: ELEVATED CLO ISSUANCE IN THE THIRD QUARTER
Source: J.P. Morgan. As of September 30, 2021.
For the most part, the elevated issuance was well-absorbed by the market. At the top of the capital structure, spreads have experienced some widening but remain fairly tight relative to history, due to continued strong demand from intuitional investors such as large banks, international buyers and insurance companies—with U.S. insurers’ CLO exposure increasing an estimated 23% last year alone.3 Given the potentially higher yields on offer relative to other fixed income asset classes, we have also seen a surge in demand from CLO equity buyers. While spreads across mezzanine traches, and BBs in particular, remain at fairly wide levels, we expect the demand for both AAA and equity, coupled with the record level of warehouses in the market, to keep new issuance strong through the remainder of the year.
That said, there are several factors at play today that could potentially impact issuance in the coming months. For one, the required transition from LIBOR to SOFR will take effect at the start of 2022. There is some thought that it may be more expensive to issue equity in SOFR, and that the basis mismatch could drive issuers to bring forward warehouses scheduled for early next year—adding more supply to the market. On the other hand, most deals issued under SOFR today contain a spread adjustment that may become unnecessary as all deals make the transition. Accordingly, supply could wane toward year-end if some market participants opt to delay issuance rather than lock in a deal with a spread adjustment.
Another interesting development in the market relates to the announcement several months ago that the Cayman Islands, where most deals today are issued, will likely be blacklisted by the European Union, impacting investors required to buy Euro risk-retention compliant deals. When this regulation ultimately takes effect, the market will most likely pivot and issue from a different, non-blacklisted entity, without much difficulty. But in the interim, investors are facing challenges when it comes to participating in Cayman-issued deals—namely the risk of buying a deal and then not being able to settle it if the announcement comes within the typical five to six-week close period. The potential unknown at play could impact participation in the market over the next couple of months, and the developing situation is one we will continue to watch.
BBs, Refis & Resets
Looking across the capital structure today, BBs look particularly attractive, in our view. Given the strong supply in the market, spreads have remained fairly wide, as mentioned, even as credit metrics and default expectations continue to improve. Based on recent market prices, the BB tranche of a CLO is currently offering roughly 1.7 times the spread of the leveraged loan market, giving investors a meaningful spread pick-up for owning the same or similar collateral in a different form.4
Across both higher-rated and mezzanine tranches, we also see value in refinancing reset transactions versus pure new issues. Due to the sheer volume of activity in the market, clean, new issue deals—with no exposure to COVID-impacted sectors—tend to garner more interest than refinancing and reset transactions, which can take more time and resources to analyze. As a result, these transactions have continued to offer a notable spread pick-up, even those from Tier I managers and with very little exposure to tail risk credits.
We expect supply to remain elevated over the next several months, although it could slow moderately at the start of 2022 as the market transitions from LIBOR to SOFR. Demand should also persist, particularly as investors move into floating-rate products in anticipation of rising rates. In our view, these dynamics will likely keep spreads range-bound through the end of the year, particularly in lower-rated BB tranches. Against this backdrop, we believe CLOs continue to look attractive, both on a standalone basis and as part of a broader, multi credit fixed income mandate. Relative to similarly rated investment grade and high yield corporate credit, for instance, CLOs not only offer the potential for incremental yield, but also—given their floating-rate coupons—can provide stability during periods of rising rates. However, given the uncertainty on the horizon and potential for short-term volatility, careful, bottom-up credit and manager selection are key, both to selecting the right opportunities and avoiding unnecessary risks.
1. Source: J.P. Morgan CLOIE Index. As of September 30, 2021.
2. Source: J.P. Morgan CLO Research. As of September 30, 2021.
3. Source: National Association of Insurance Commissioners. As of October 7, 2021.
4. Source: Based on Barings’ market observations. As of September 30, 2021.