By the Numbers

Loan market woes may keep CLO spreads wide

Caroline Chen | July 22, 2022

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Current woes in the leveraged loan market may keep CLO spreads at wide levels for the balance of the year. Low prices on leveraged loans have trapped a sizable number of CLO deals in warehouses, creating an overhang of potential supply. And low prices have also kicked off a surge in print-and-sprint deals, adding uncertainty to the supply pipeline. Low prices have also triggered outflows from retail loan funds. Higher interest rates and slower growth look likely to keep loans and CLO spreads under pressure.

As investors have demanded higher risk premiums to compensate for the rising uncertainty, more loans have traded at discount to par. The share of the S&P/LSTA Leveraged Loan Index trading at $95 and above dropped from 93% at the start of the second quarter to 29% at the end (Exhibit 1). The share of the index trading at $90 and below rose to 16%.

Exhibit 1. A sharp decline of $95 and above loans in the index in 2Q

Note: data represents the average bid price in the S&P LSTA leveraged loan index at month end
Source: S&P LCD, Amherst Pierpont Securities

A supply overhang in aged warehouses may put CLO spreads on hold

Current pricing leaves the economics for issuing CLOs unfavorable if the manager used a warehouse line to buy loans at a low margin and around par in 2021 or earlier this year. Forty warehouses under US Bank administration were open for nine months or more as of the end of the second quarter, representing 37% of total warehouses open (Exhibit 2). The share is more than double the 17% in at the end of the first quarter. When those aged warehouses approach maturity, the pressure for issuing a deal, adding equity or liquidating assets should loom large, creating an overhang of potential supply.

Exhibit 2: The share of aged warehouses continues to climb

Note: Data reflects warehouse lines administered by US Bank. Dates are reporting periods reflecting prior month activities.
Source: US Bank, Amherst Pierpont Securities

A rising share of short CLOs may pressure new issue spreads

CLOs with a 2-year non-call and 5-year reinvestment period, or 5NC2, dominated the primary market when loan prices trade near par at the beginning of the year. But the primary market has since seen a rising share of short CLOs as loan prices fell. The return of print-and-sprint CLOs has contributed to the increasing numbers of deals with 1-year non-call and 3-year reinvestment periods in the second quarter. It is not certain whether short CLOs are all print and sprint types, but investors in those deals are more opportunistic and demand wider spreads. By contrast, investors in the 5NC2 CLOs, especially ‘AAA’ investors, often locked the spread at tighter levels before pricing. For example, a 5NC2 Madison Park 2022-55A CLO priced its ‘AAA’ class at 185 bp on July 6, but a 3NC1 Madison Park 2022-62A CLO priced its ‘AAA’ class 40 bp wider at 225 bp a week later.

In the first two weeks of July, only two of 13 broadly syndicated loan CLOs priced in primary with a 5NC2 structure. But the share of 3NC1 CLOs rose to 54%. The average liability cost over SOFR in the 3NC1 CLOs was 269 bp, an additional 11 bp concession to the 5NC2 deals priced in July (Exhibit 3).

Exhibit 3: CLOs liability cost inched higher with the rising numbers of short deals

Note: July data as of July 15, 2022. Market share is based on the number of the deals priced in primary market.
Source: Bloomberg, Amherst Pierpont Securities

Headwinds from loan funds redemptions

CLOs are the largest buyers of leveraged loans followed by the nearly $160 billion leveraged loan fund complex. Loan funds are more vulnerable to run risk than any other type of debt funds, according to recent work by the New York Fed (here). Loan fund flows are particularly sensitive to weak fund performance. Loan funds had $10 billion in total outflows in May and June as the average bid price in the loan index slid from $97.50 to $92.00. This is not the sole episode supporting the research conclusion from the New York Fed. In December 2018, prime loan funds had a large $18 billion outflow amid a looming trade war and following a drop in average bid price in the loan index from $98.00 to $93.80. A $15 billion outflow happened in March 2020 after the average price in the index touched a historical low of $82.8.

Although the New York Fed report does not examine the impact of loan funds’ run risk on CLO spreads, weak demand from loan funds is more likely to put CLO spreads on a widening cycle than a tightening cycle, all else equal. For example, the ‘AAA’ CLO index DM gapped out nearly 50 bp in the past two months. The relationship can also be seen in other episodes when prime loan fund outflows accelerated, or inflows decelerated. The ‘AAA’ CLO spreads were on the trajectory of softening in most of those times (Exhibit 4).

Exhibit 4. Weak loan funds demand may pressure CLO spreads

Note: The grey shaded area represents periods that prime loan funds having increasing outflows or declining inflows along with widening of CLO ‘AAA’ spreads.
Source: LCD, Bloomberg, Amherst Pierpont Securities

For investors able to take mark-to-market volatility, the widening of CLO spreads provides good coupon carry. Spreads of highly rated CLO tranches are at their historical wide against corporate investment grade debt. With a long enough horizon, carry can compound to offset the impact of volatile spreads.

Caroline Chen
caroline.chen@santander.us
1 (646) 776-7809

This material is intended only for institutional investors and does not carry all of the independence and disclosure standards of retail debt research reports. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.

This message, including any attachments or links contained herein, is subject to important disclaimers, conditions, and disclosures regarding Electronic Communications, which you can find at https://portfolio-strategy.apsec.com/sancap-disclaimers-and-disclosures.

Important Disclaimers

Copyright © 2023 Santander US Capital Markets LLC and its affiliates (“SCM”). All rights reserved. SCM is a member of FINRA and SIPC. This material is intended for limited distribution to institutions only and is not publicly available. Any unauthorized use or disclosure is prohibited.

In making this material available, SCM (i) is not providing any advice to the recipient, including, without limitation, any advice as to investment, legal, accounting, tax and financial matters, (ii) is not acting as an advisor or fiduciary in respect of the recipient, (iii) is not making any predictions or projections and (iv) intends that any recipient to which SCM has provided this material is an “institutional investor” (as defined under applicable law and regulation, including FINRA Rule 4512 and that this material will not be disseminated, in whole or part, to any third party by the recipient.

The author of this material is an economist, desk strategist or trader. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM or any of its affiliates may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.

This material (i) has been prepared for information purposes only and does not constitute a solicitation or an offer to buy or sell any securities, related investments or other financial instruments, (ii) is neither research, a “research report” as commonly understood under the securities laws and regulations promulgated thereunder nor the product of a research department, (iii) or parts thereof may have been obtained from various sources, the reliability of which has not been verified and cannot be guaranteed by SCM, (iv) should not be reproduced or disclosed to any other person, without SCM’s prior consent and (v) is not intended for distribution in any jurisdiction in which its distribution would be prohibited.

In connection with this material, SCM (i) makes no representation or warranties as to the appropriateness or reliance for use in any transaction or as to the permissibility or legality of any financial instrument in any jurisdiction, (ii) believes the information in this material to be reliable, has not independently verified such information and makes no representation, express or implied, with regard to the accuracy or completeness of such information, (iii) accepts no responsibility or liability as to any reliance placed, or investment decision made, on the basis of such information by the recipient and (iv) does not undertake, and disclaims any duty to undertake, to update or to revise the information contained in this material.

Unless otherwise stated, the views, opinions, forecasts, valuations, or estimates contained in this material are those solely of the author, as of the date of publication of this material, and are subject to change without notice. The recipient of this material should make an independent evaluation of this information and make such other investigations as the recipient considers necessary (including obtaining independent financial advice), before transacting in any financial market or instrument discussed in or related to this material.