In Q2 2023, US CLO debt tranches delivered strong returns across the stack driven by increasing carry and uptick in prices.
CLOs – 2Q Review
- In Q2 2023, US CLO debt tranches delivered strong returns across the stack driven by increasing carry and uptick in prices. These returns registered 2.07%, 2.51%, 3.7%, 3.93%, 4.86%, 4.64% for AAA, AA, A, BBB, BB and B rating cohorts, respectively. On a YTD basis, returns are tracking 3.83%, 4.85%, 5.84%, 6.24%, 8.44%, 8.24% respectively.
- The strong recovery in loan secondary prices in June reversed the softness observed in May. This helped improve market value metrics such as weighted average purchase price (WAPP), BB market value overcollateralization (MVOC) and equity net asset values (NAVs). The continued loan downgrade activity, pick up in default pace and increase in dispersion among some of the weaker/stressed issuers have resulted in an increase in loan portfolios tail risk metrics; thereby, disproportionally impacting older vintage deals which are exhibiting degradation in structural metrics with thin interest-diversion test/overcollateralization (IDT/OC) cushions. Across US CLO portfolios for reinvesting deals (using Deutsche Bank CLO Research Stats), structural metrics softened while credit metrics held up. Weighted average rating factors (WARFs) and CCC concentration remain manageable at 2820 and 3.7% and 4.5% (Moody’s/S&P), respectively. OC and IDT test breaches ticked up slightly and are now tracking 1.6% and 3.5%, respectively. CLO mezzanine downgrade activity by the rating agencies remains very minimal for now.
- Direction of spreads and any potential tightening going forward will be influenced by various developments, including new issue supply, relative value vs. other structured/corporate products, renewed AAA demand from the large US banks, continued support from Japanese investors, National Association of Insurance Commissioners (NAIC) rulings on capital charges for below investment-grade (IG) tranches, deterioration in macro and spread decompression in credit.
- Issuance volume decelerated through the second half of the quarter. The overall arbitrage environment remains challenging given the relatively wide liability cost and scarcity of third-party equity buyers. CLO warehouse activity has decelerated, and balances are back to 2021 levels (down by roughly 50% from 2022 peaks and down 30% from beginning of the year). Structural metrics remain strong and credit metrics (while still healthy) are showing some dispersion signs in older vintage deals. Spreads levels are expected to be range bound (to slightly tighter) through the summer months with potential for widening later in the year if the macro-outlook worsens and credit fundamentals deteriorate. Issuance projections for the full year are being slightly reduced to the $100 billion range.
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.
- Key themes from Q1 continued into Q2. A supportive technical and a still stable fundamental backdrop in the US CLO market helped deliver another strong quarterly performance. Relative value across the stack looks favorable vs. other comparable asset classes.
- Through the first half of the year, CLO refinancing (refi) and reset activities were non-existent. Post-reinvestment deals are now causing some syndication challenges for loan issuers looking to address their respective maturity walls, which has resulted in increased “bond for loan” takeout in recent capital market activities. CLO refis/resets will remain difficult to execute given the wider liability backdrop. This remains an important dynamic to monitor closely given the quantum of CLOs exiting their end of reinvestment periods, estimated at $330 billion by year end 2023 (about 40% of the US CLO universe).
- As of Q2 and based on JP Morgan market estimates, roughly 22.9% of the floating-rate US CLO debt market (roughly $863 billion in market size) is priced to 3M Term SOFR. In CLO portfolios, 63.3% of loan exposures are priced to SOFR. CLO portfolios have exposure to various benchmarks with the largest base rates being the following: 1M Term SOFR (33.2%), 1M Libor (28.9%), 3M Term SOFR (18.3%), 3M Libor (16.3%), 6M Libor (0.6%), and 6M Term SOFR (0.6%), while the remaining 2.1% are comprised of Fixed, Prime, 2M Libor, 1YR SOFR and 1YR Libor.
- Looking ahead, we continue to like the current yield on offer across the CLO mezzanine tranche universe. Returns are benefiting from increasing coupons and relative value looks attractive vs. other comparable asset classes. While we expect spreads to remain range bound (and possibly tighten) in the medium term, we’re cognizant of potential for some widening later in the year if the macro environment worsens and loan credit fundamentals deteriorate. This view drives our bias towards more opportunistic selections (primary and newer vintages) and defensive positioning (tier one managers and cleaner portfolios). We remain constructive on BBBs with current yields in the high single digits. As for BBs, we remain selective and prefer deals with stronger subordination and high-quality portfolios that are offering double digit base case yields.
Sources: BofA Global Research, Morgan Stanley Research, and J.P. Morgan.
Leveraged Loans – 2Q Review
- Against a challenging macro backdrop, the US loan market delivered a strong performance in Q2, as the Morningstar® LSTA ® US Leveraged Loan Index (Index) returned 3.15% during the quarter. Overall, the average loan index bid price increased by 86 bp to 94.24, a level not seen since the banking-related volatility in March. Loans have benefited from high coupons given elevated base rates (3M SOFR currently well above 5%) and are tracking a robust 6.48% return through the YTD period, representing the strongest start for any comparable timeframe since 2009.
- Secondary trading levels moved higher across the board during the quarter. Similar to the prior quarter, lower rated loans continued to outperform higher rated-credits, as BBs, Bs and CCCs returned 2.81%, 3.25% and 4.39%, respectively. On a YTD basis, lower-rated credits have outperformed with returns for BBs, Bs, and CCCs coming in at 4.95%, 7.19%, and 8.47%, respectively.
- Overall, technicals have weakened as of late on the back of decelerating CLO formation, although slowing retail outflows have provided a positive counterbalance. CLOs exiting reinvestment periods are starting to pose some syndication challenges (inability to extend given failing WAL tests) for the some of the issuers/arrangers. However, lower loan issuance has provided some tailwinds to secondary prices. Rising base rates alongside positive market value upticks have resulted in solid loan performance for the year, ahead of other fixed income asset classes.
- Supply in the primary market remained low in Q2. Total institutional volume amounted to $49.6 billion during the quarter, versus $55.9 billion for the comparable period last year. Consistent with the prior quarter, activity remained heavily tilted towards opportunistic transactions aimed at addressing upcoming maturities, although there were a few acquisition-related offerings in the issuance mix as well. YTD volume through June is at the lowest point for any comparable period since 2016 at just $103 billion, of which roughly two-thirds represent refinancings.
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).
- On the investor front, CLO volume decreased to $21.6 billion from $33.5 billion in the previous quarter, representing a 36% decline quarter over quarter. For additional context, 2Q23 represented the lowest quarterly issuance since 2Q20. Meanwhile, the US CLO market saw no refi and two resets (totaling $0.8 billion) this quarter. Refis are nonexistent versus $3.8 billion in comparable period last year, while resets are down materially year-over-year (YOY) (versus $20.6 billion).
- The global CLO market surpassed $1 trillion in 2021 and will likely reach $1.2 trillion sometime in 2023. Continued solid formation in Q2 further increased the size of the US CLO market, which currently stands above $978 billion as of the first quarter, equating to more than a 100% increase from the start of 2017.
- While retail outflow activity decelerated in the final month of Q2, investors still withdrew $7.8 billion in aggregate from funds in during the quarter. YTD outflows have amounted to approximately $18.5 billion.
- Default activity remained a theme in 2Q. There were seven defaults in the index during the quarter, as the trailing 12-month default rate by principal amount increased by 39 bp to 1.71% (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 begin to weigh on highly leveraged balance sheets.
- The ratio of downgrades to upgrades decelerated in Q2, with the rolling 3-month downgrade-to-upgrade ratio increasing to 2.37x (from 2.46x in 1Q23). Key downgrade themes include earnings, margin pressure, elevated leverage levels, increased borrowing costs and 2021 vintage loans not achieving realized synergies.
- Looking ahead, we believe credit decompression among lower quality borrowers is highly probable in the second half of the year given the higher rates environment and muted economic growth. While companies have seen an inflection point on supply chain issues, elevated input costs and peak in labor shortages/cost pressure, we expect corporate margins to be impacted by decelerating revenue, as volume declines offset prior price increases (limited ability to continue to pass through into consumers). Understandably, corporate fundamentals for companies could become more challenged, resulting in higher dispersion across sectors, weaker issuers, and ratings cohorts. However, supportive technicals could provide a favorable backdrop in the medium term due to ramping CLOs and light new-issue supply.
Source: BofA Global Research, LCD, Morningstar ® LSTA ® Leveraged Loan Index.