By the Numbers

An overhang of aging warehouses should leave CLO spreads soft

Caroline Chen | October 28, 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.

New issue CLO spreads have continued to soften in October, and the overhang of aged CLO warehouses may be a factor. Twelve broadly syndicated CLOs priced so far this month at a median ‘AAA’ spread of 218 bp over SOFR, 18 bp wider than the median level in September. New issue spreads may stay weak until investors see signs of easing in aged warehouses.

Over 50% of warehouses were open for more than nine months at the end of 3Q

The number of outstanding warehouses has been declining since the spring, but the average age of warehouses continues to climb. According to the US Bank, the number of warehouses under its administration decreased to 97 in September from 103 a month ago, but 49 warehouses or 50.5% have been open for more than nine months. By contrast, only eight warehouses, or 9% were aged more than nine months at the beginning of the year (Exhibit 1).

Exhibit 1. Aged warehouses continue to build up

Note: Share represents the number of warehouses in each age bucket over the total outstanding warehouses. Warehouse data is shown for the reporting month, reflecting activity in the prior month. Data reflects warehouse lines administered by US Bank only. The estimated U.S. Bank market share is around 50%-52%.
Source: US Bank, Amherst Pierpont Securities

The rising share of aged warehouses implies a growing number of CLO deals may be stuck. The current market price of loans in aged warehouses are likely lower than the purchase price, especially those purchased at the beginning of the year. With leveraged loan prices down 6.7% this year, lenders to aging warehouses face mounting credit and market risk may eventually pressure managers for an exit strategy. CLO managers have a few options:

Liquidate loans in the market and end the warehouse relationship
Inject fresh equity capital to the aged warehouses
Negotiate for a warehouse maturity extension
Do a CLO takeout with an affordable structure

Since most warehouses today do not have mark-to-market triggers, this may be the least likely option a manager will choose. A lender-forced warehouse liquidation could weigh on already beaten-down leveraged loan prices. More importantly, it is credit negative news to investors and may push spreads wider on all of a manager’s outstanding CLOs.

Equity injection becomes an expensive option for managers. For example, a 90% advance rate in a $200 million warehouse will require $20 million initial equity capital. The advance rate in warehouses is usually set as a percentage of the lower purchase price and market price. If the market price of loans dropped by 7% from par, a manager needs to put in an additional $12.6 million equity capital into the warehouse.

That leaves the possibility of negotiating for a maturity extension. The success of the negotiation highly depends on the relationship between lenders and managers as well as both parties’ outlook on the market. However, maturity extension does not solve the overhang problem but only kicks the can down the road.

A CLO takeout remains the ultimate solution for managers to clear their warehouses. In the primary market, investors have already demanded higher spread concession this year under the rising risk of recession, not to mention if a CLO were packed with all underwater loans. The rising share of aged warehouses implies to investors a wave of CLOs may have to tap the market as those warehouses approach maturity. And that supply overhang will only weigh on demand in the primary market and push spreads out further. Since managers may have little power in setting spread levels this year, they work on the structure to keep the arbitrage working. For example, the primary market has seen a rising share of static CLOs. A static CLO helps managers to reduce liability costs as the ‘AAA’ tranche will amortize after the deal closes.

Warehouses closed out for CLOs may be younger warehouses

The average number of new warehouses opened each month has been around nine since the spring. But the number of warehouses rolling off into CLOs picked up recently, causing the overall decline of the outstanding warehouses. For example, nine new warehouses opened in September but 15 were closed, a net change of six, according to the US Bank data (Exhibit 2). Most warehouses closed out for CLOs may be the young warehouses, part of the reason for the rising share of aged warehouses.

Exhibit 2. The number of warehouses closed outpaced warehouses opened

Note: Warehouse data is shown for the reporting month, reflecting activity the month before. Data reflects only warehouse lines administered by US Bank. The estimated U.S. Bank market share is around 50%-52%.
Source: US Bank, Amherst Pierpont Securities

Trading activities may indicate a close to fully built portfolio in the aged warehouses

The average trading activity in the 49 warehouses aged more than nine months went up 2% month-over-month to $262 million in September but was a 9% decline quarter-over-quarter (Exhibit 3). The average traded par in all outstanding warehouses was $192 million as of September, a 9.4% quarter-over-quarter decline as well. Traded par often rises as a CLO ramps up a portfolio and falls after a portfolio is fully built. Once a warehouse is fully built, the pressure for CLO takeout mounts on the manager.

Exhibit 3. The average trading activities in warehouses have been declining

Note: Warehouse data is shown for the reporting month, reflecting activity the month before. Data reflects only warehouse lines administered by US Bank.
Source: US Bank, Amherst Pierpont Securities

During the pandemic, the share of warehouses aged nine months or more was 39% in the third quarter of 2020 and 42% in the fourth 2020, both lower than today’s 50.5% level, according to the US Bank. The potential wave of supply from the aged warehouses coupled with investors’ recession concerns will stretch the already weakened investors’ demand this year and may keep CLO spreads on the soft side.

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

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