The US CLO market was resilient in Q1 2023 delivering positive returns across the debt stack.
CLOs – 1Q Review
- The US CLO market was resilient in Q1 2023 delivering positive returns across the debt stack. US CLO tranches delivered favorable returns across the stack despite the macro vol driven by both positive coupon and price returns. These returns registered 1.76%, 2.34%, 2.14%, 2.31%, 3.58%, 3.60% for AAA, AA, A, BBB, BB and B rating cohorts, respectively.
- The loan market price recovery in Q1, particularly in the first half, benefited the slight increase in market value metrics such as weighted average purchase price (WAPP), BB market value overcollateralization (MVOC) and equity net asset value (NAV). The continued loan downgrade activity, pick-up in default pace and increase in dispersion among some of the weaker/stressed issuers has resulted in an increase in loan portfolios tail risk metrics. As noted last quarter, CLO fundamentals remain favorable but continue to decelerate resulting in some degradation in structural metrics in older vintage deals with thin cushions. Overall metrics remain healthy for now: median US junior overcollateralization (OC) cushions are tracking 4.5%, only 2% deals are failing junior OC test, median defaulted exposure in US CLOs is approximately 0.5% (vs. 1.32% for the Morningstar® LSTA ® US Leveraged Loan Index; the “Index”), CCC-rated exposure remain stable and weighted average rating factor (WARF) levels are in check.
- Spreads across the debt stack tightened through the first two months and tested YTD tights in February only to widen as the market endured the Silicon Valley Bank (SVB) fallout. Towards the end of the quarter, spreads managed to retrace roughly 50% of the March widening. Any potential tightening going forward will be influenced by various developments: new issue supply, relative value vs. other structured/corporate products, renewed AAA demand from the large US banks, continued support from Japanese investors, NAIC rulings on capital charges for below investment grade (IG) tranches and any further deterioration in macro.
- Issuance was off to a strong start, second highest level (except for 2021) post GFC. While the CLO arbitrage slightly improved in March, it remained very tight and restrictive for normal deal execution. Issuance continues to be driven by established managers that have raised captive CLO equity funds, newer CLO managers with backstop equity commitments from their parent companies and warehouse cleanup/liquidation trades. For the market to sustain any meaningful issuance, CLO spreads will need to tighten unless loan issuance picks up or loan spreads widen from current levels. For 2023, issuance forecasts remain in the $100-$120 billion range.
U.S. CLO Issuance ($ Billions)
January 1, 2018 to March 31, 2023
U.S. CLO Arbitrage at Issuance (Bps)
January 1, 2018 to March 31, 2023
U.S. CLO BWIC ($ Billions)
January 1, 2018 to March 31, 2023
Sources: LCD, BofA Global Research, Ratings refer to original rating, and spreads are generic. Actual spreads may differ based on structure, WAL, collateral and manager.
- The US CLO market was resilient in Q1 delivering positive returns across the debt stack. Quarterly issuance volume was strong despite significant decline in loan issuance volumes, broader macro vol/headwinds spread widening in March, generally difficult arbitrage environment and the banking crisis that impacted the US regional banks.
- CLO refinancing (refi) and reset activities, similar to the trend in second half of 2022, remain difficult to execute given the wider liability backdrop. This remains an important dynamic to monitor closely given the quantum of CLOs exiting their respective end of reinvestment periods, estimated at about $330 billion by year end 2023 (approximately 40% of the US CLO universe). Any pickup in refi/reset market activity and even redemptions will be driven by tightening in liability spreads as well as CLO equity internal rate of return (IRR) performance and if loan prices can recover some ground.
- As of Q1, based on JP Morgan market estimates, 20.2% of the floating-rate US CLO debt market (roughly $855 billion in market size) is priced to 3M Term SOFR. In CLO portfolios, 34.0% of loan exposures are priced to SOFR, which compares to roughly 35.9% for the Index. CLO portfolios have exposure to various benchmarks with the largest base rates being as follows: 1M Libor (41.4%), 3M Libor (24.1%), 1M Term SOFR (18.8%), 3M Term SOFR (13.0%), 6M Libor (0.5%), and 6M Term SOFR (0.5%).
- Looking ahead, our views from earlier in the year remain unchanged. We maintain a selective, opportunistic and defensive view and positioning. While we acknowledge potential for spread widening from current levels and expect mezzanine prices to be pressured by the myriad of challenges (corporate earnings, timing/depth of a recession, macro developments, Federal Reserve (Fed) rates policy), CLO tranches look attractive due to historical wide levels, favorable coupons and yields, strong structural protections, and ability to withstand mild recessionary stress scenarios. We continue to view the current wider yields on offer favorably and remain constructive on BBBs with current yields at high single digits. As for BBs, we remain selective and still like the structural protections offered by high quality portfolios that are offering double digit base case yields.
U.S. CLO 2.0/3.0 Secondary Spreads (Bps)
January 1, 2018 to March 31, 2023
Equity NAVs, BBB MVOCs, BB MVOCs
Periods: 2015-2016, 2018, 2020 and October 31, 2022
U.S. CLO Tranche Average Price
March 1, 2018 to March 31, 2023
Sources: BofA Global Research, Morgan Stanley Research, and J.P. Morgan.
Leveraged Loans – 1Q Review
- Despite the volatility and SVB/regional banking crisis that emerged in March, the US loan market closed Q1 on a high note, as the Index returned 3.23% during the quarter. Overall, the average loan index bid price increased by 94 bp to 93.38, primarily attributable to strong performance in the first two months of the quarter, as well as the last week of the quarter in which some of the earlier March softness was retraced. For the quarter, loans underperformed equities, investment grade and high yield bonds, as fixed-rate assets generally outperformed given the sharp rally in Treasuries. For context, loans returned 3.23%, while investment grade and high yield bonds returned 3.61% (Morningstar US Corporate Bond Index) and 3.68% (Morningstar US High-Yield Bond TR USD), respectively.
- Secondary trading levels were volatile in March, driven by the SVB and other bank developments but managed to retrace most of the softness towards the end of the quarter as the broader markets recovered post the Fed/FDIC intervention. Lower-rated credits outperformed higher-rated credits in Q1, as Double-Bs, Single-Bs and CCCs returned 2.08%, 3.81% and 3.92%, respectively.
- New-issue supply remained low, given the challenging backdrop for new deals to launch. This quarter, issuance was mainly driven by maturity extension transactions. Total volume amounted to $52.5 billion, the slowest reading for first-quarter issuance in seven years. The size of the loan market, as represented by total Index outstandings, declined by $14.53 billion in the first quarter to $1.4 trillion.
- On the demand side, CLO issuance remained in high gear, as managers priced $33.6 billion of 79 new deals in Q1 which is ahead of last year’s pace of $31.2 billion. New issue volumes were up 7.58% year over year (YoY). Meanwhile, the US CLO market saw one refi (totaling $0.4 billion) and no resets this quarter. Refis are nonexistent versus $3.5 billion in comparable period last year, while resets are down materially year-over-year (YOY) (versus $17.9 billion).
Average Bid: Morningstar LSTA LLI
March 1, 2017 to March 31, 2023
Average 3-YR Call Secondary Spreads: Morningstar LSTA LLI 2,3
March 1, 2017 to March 31, 2023
Loan Issuance and Repricing Activity ($ Billions)
January 1, 2019 to March 31, 2023
Source: LCD, The Morningstar ® LSTA ® Leveraged Loan Index. Past performance is no guarantee of future results. Investors cannot invest directly in the Index. *The Index’s average nominal spread calculation includes the benefit of LIBOR floors (where applicable).
- The global CLO market surpassed $1 trillion in 2021 and will likely reach $1.2 trillion sometime in 2023. Continued solid formation in Q1 further increased the size of the US CLO market, which currently stands above $967 billion as of the first quarter, equating to more than a 100% increase from the start of 2017.
- On the other hand, retail loan fund investors continued to exit the market, as $10.77 billion was withdrawn from funds during the quarter, representing a 43.72% decline YOY.
- Overall, loan technicals have remained supportive as CLO demand continued to offset retail outflows given the lower new-issue primary backdrop. Stronger Single-B and BB-rated loans continued to be well bid and held in well during recent bouts of vol as the loan market softened during the first three weeks of March. However, technicals still lack tremendous depth and are highly correlated to retail outflow trends and CLO buying activity associated with new issue primary ramp and secondary cash deployment.
- Default activity saw an uptick in 1Q. There were eight defaults in the index during the quarter, as the trailing 12-month default rate by principal amount increased by 60 bp to 1.32% (remains well below historical average). Default rates are expected to increase closer to historical averages in 2023, as cumulative effects of higher interest rates and increasing margin pressure began weigh on highly leveraged balance sheets.
- The ratio of downgrades to upgrades decelerated in Q1, with the rolling 3-month downgrade-to-upgrade ratio increasing to 2.46x (from 2.77x in 4Q22).
- As we look ahead, we expect leveraged finance markets to remain impacted by myriad of macro developments, evolving Fed policy, inflation/payroll data, fallout from regional banks/tighter financial conditions most importantly corporate fundamentals – Q1 earnings & forward guidance. Loan fundamentals, while still favorable, are showing signs of deterioration especially across lower-rated issuers. While overall metrics look favorable versus pre-pandemic levels, the market will be acutely focused on the impact of “higher for longer” rates environment (if sustained) and secondary impact from tighter credit conditions (regional banks), both of which will be a key focus during the next round of quarterly earnings. Unsurprisingly, loans have become more heavily correlated to movements in macro sentiment than is typical for the asset class given the recent developments that have impacted broad risk sentiment.
U.S. CLO Market Size ($ Billions)
January 1, 2017 to March 31, 2023
CLO Volume and Retail Fund Flows ($ Billions)
January 1, 2019 to March 31, 2023
Lagging 12M Default Rate: Morningstar LSTA LLI (4)
March 1, 2017 to March 31, 2023
Source: BofA Global Research, LCD, Morningstar ® LSTA ® Leveraged Loan Index.