Lessons learned in CLOs in 2022

Steven Abrahams and Caroline Chen | December 16, 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.

This year provided a few good lessons on bear markets in CLOs. The market closed to some managers but stayed open to others. Performance in ‘AAA’ debt stayed positive while other classes did not. And many managers and equity investors that came into the year with great aspirations are still sitting in warehouses and looking for an exit. “The world breaks everyone,” Hemingway once wrote, “and afterward many are strong at the broken places.” We will likely see if that proves true next year.

#1 Some managers can issue through bull and bear markets, many cannot

The ability of a CLO manager to issue through strong and weak markets matters, especially to investors that put time and effort into due diligence on different platforms. This year highlighted the advantages that come to a manager and to investors from frequent issuance. In 2021, for example, 112 different managers brought deals to market (Exhibit 1). The number of deals ranged from a single deal for 34 managers to more than 10 deals for two managers. Then the bull market of 2021 gave way to the bear market of 2022. In this year’s bear market, half of the managers that brought only a single deal in 2021 entirely dropped out, issuing no new deals. But all of the managers that brought five or more deals in 2021 returned this year with multiple deals. Investors that had done due diligence on frequent issuers saw continuing opportunity to deploy capital.

Exhibit 1. Frequent issuers could issue in bull and bear markets

Note: percentages in the exhibit are represented by manager count. For example, 34 managers issued only one deal in 2021, of which 17 continued to issue one in 2022, 3 brought 2-4 deals and 17 did not issue any CLOs in 2022.  Twelve managers didn’t issue in 2021 but offered new CLOs in 2022.   New issuance data as of Dec 9, 2022.
Source: LCD Pitchbook, Amherst Pierpont Securities

Frequent issuers in 2021 became frequent issuers in 2022. The names are likely familiar (Exhibit 2). Frequent issuance for a manager tends to attract investors that plan on doing extensive due diligence and hope to apply the work to investment opportunities through changing markets. On the other hand, a broad audience of investors tends to make frequent issuance easier. It is a virtuous cycle.

Exhibit 2. Fourteen managers have issued five or more CLOs in both years

Notes: new issuance data as of December 9, 2022.
Source: LCD Pitchbook, Amherst Pierpont Securities

#2 ‘AAA’ CLO performance holds up in bull and bear markets

‘AAA’ CLOs have a long history of delivering relatively efficient total returns—relatively high returns for the amount of risk. And that played out again in 2022 (Exhibit 3). By taking annualized daily total returns in each CLO rating class and dividing it by the annualized risk or standard deviation of those returns, ‘AAA’ debt again stood out. ‘AAA’ CLOs had delivered the highest ratio of return-to-risk each year since 2017 and did that again in 2022. ‘AAA’ delivered 61 bp of return for each unit of risk while other rating classes lost money.

Exhibit 3.  ‘AAA’ CLOs outperformed after risk adjustment

Notes: Sharpe ratios are calculated by dividing annualized daily Palmer Square index total returns over the annualized return standard deviation.  Palmer Square index data as of December 13, 2022.
Source: Bloomberg, Palmer Square CLO index, and Amherst Pierpont Securities

The consistent efficiency of ‘AAA’ CLO returns suggests opportunity to leverage those into a better performance than the ones available in the long run from other classes of CLO debt. The high performance crowd in the CLO market may see ‘AAA’ CLOs as a bit dull, but beneath that façade are some very interesting potential returns.

#3 Getting into a CLO warehouse can be easy, getting out can be hard

Finally, this year brought the saga of CLO warehouses. A big pipeline of issuers came into the year expecting to continue the run of 2021 and then ran into a sudden and persistent drop in loan prices and a widening of debt spreads. The share of warehouses aged nine months or more built throughout the year and now stands around half of all outstanding lines. This year will likely become a case study for managers and CLO equity investors on ways to manage a hung warehouse: stay in the warehouse and hope things change, issue short deals and hope to refinance or reset into longer deals later, issue static deals, split the loan pull and try to print-and-sprint toward better economics. The warehouse saga continues. And with the risk of downgrades in ‘B-/B3’ loans growing, the case study is only likely to get more interesting.