The Big Idea
A midterm exam in CLOs
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.
Higher rates looked bound to keep the pressure on leveraged loans at the beginning of the year, and that has proven true, with annual downgrades in ‘B-‘ loans on track to top 20%. That keeps the pressure on CLO equity and junior debt classes. The promise of good value in static CLOs has fallen short, largely because issuance has shifted away from static structures. And the LIBOR-to-SOFR transition has also fallen short, another risk for equity. New facts, new views.
‘CCC’ exposure in CLOs is on track to approach or exceed May 2020 levels
Collateralized loan obligations (CLOs) are clearly on track to reach or exceed the ‘CCC’ threshold that would put junior classes at risk of seeing principal and interest diverted to senior classes. That would happen if junior overcollateralization tests failed. The average exposure of CLOs to assets rated ‘CCC’ or lower is currently around 6.2%, leaving a narrow margin to the typical 7.5% threshold that raises pressure on junior classes.
Particularly vulnerable are CLOs issued in 2018 or earlier. Many of these CLOs are either in the post-reinvestment period or nearing the end of the reinvestment period this year. As a result, these CLOs hold ‘CCC’ assets that, on average, surpass or approach the 7.5% threshold (Exhibit 1).
Exhibit 1: Early vintages CLOs already have high ‘CCC’ asset exposure
Notes: Data includes BSL CLOs with ‘CCC+ or lower’ threshold at 7.5% or lower. Data as of July 11, 2023, reflecting CLO performance based on June reports. Static CLOs and CLOs with collateral factors less than 1% are not included. Data source: INTEX, Santander US Capital Markets, LLC
Downgrades of ‘B-‘ issuers this year are on track to exceed the 22-year median of 18%. From January through May, S&P downgraded 9% of the ‘B-‘ issuers in the leveraged loan index. This translates to an approximate 10.3% by June or an annualized rate of 20.6%, signaling a significant uptick in downgrades.
If the pace of ‘B-‘ downgrades continues through December, it would add another 3.1% in ‘CCC’ exposure to CLOs’ loan portfolio. This estimate comes from multiplying 30% of ‘B-‘ loans in the average CLO portfolio by the projected downgrade rate of 10.3% for the remaining six months in 2023. That would leave ‘CCC’ exposure in the range of 8% to 13% for most CLOs. As of May 2020, according to S&P, ‘CCC’ or lower-rated assets accounted for an average of 12.3% of CLO holdings.
The potential high ‘CCC’ concentration in CLOs may leave the spreads of ‘BB’ rated CLO bonds on the wide side in the second half of the year, making manager selection a key factor in playing the lower part of the CLO capital stack.
Static CLO ‘AAA’ classes provide good value
Static CLO issuance surged in the second half of last year to address mounting credit concerns. To attract investors, some managers issued static CLOs for the transparency of portfolio risk over the life of the deal and the fast build-up of bond credit enhancement. The ‘AAA’ bonds in those static CLOs appealed to buy-to-hold investors due to the shorter weighted average life, higher coupon income, and better structural credit protection. Crescent Capital’s ATSTC 2022-1A Class A, for example, a static CLO priced in July last year, has delivered a better total return than the CLO ‘AAA’ index and Bloomberg US Aggregate Total Return index in the first half of 2023 (Exhibit 2, see also the Appendix: A sample bond total return calculation).
Exhibit 2: Total return comparison of a sample static CLO ‘AAA’ and indices
Notes: The WAL for ATSTC 2022-1A Class A is based on a 20% CPR. ATSTC 2022-1A Class A start price at YE 22 and the end price on 6/30/2023 are assumed to be the same as Palmer Square CLO AAA price. A 5% reinvestment rate in the holding period is based on the average of 3m SOFR rate. Data source: INTEX, Bloomberg, Santander US Capital Market LLC
However, this relative value opportunity is hard to find this year. While CLO arbitrage remains difficult, ‘AAA’ new issue spreads have tightened along with the leverage loan price rally. Managers who issued static CLOs last year have returned to the market in 2023 with non-static CLOs and tighter spreads for better deal economics. For example, Crescent brought a non-static CLO to the new issue market this month with ‘AAA’ pricing 40 bp tighter than a year ago, at 220 bp over SOFR.
With static CLO issuance slowing to a trickle, investors looking for high-quality, short-duration paper in CLOs may prefer post-reinvestment period ‘AAA’ from managers with high repayment rates.
LIBOR-SOFR transition fell short
The LIBOR-SOFR transition had a slow start at the beginning of this year. Despite a faster pace in later months, managers on average had only 50% SOFR loans in the CLO portfolios by the time LIBOR went away at the end of June (Exhibit 3).
Exhibit 3: SOFR loans were nearly 50% of CLO portfolios by June month-end
Notes: Data reflects outstanding US BSL CLO as of June 2023. Source: INTEX, Santander US Capital Markets LLC
Meanwhile, over the balance of the year, a vast majority of CLO debt should transition to 3-month SOFR with a 26 bp credit spread adjustment (CSA) based on the hardwired fallback language in the CLO documents. Equity should come under pressure. The CSA application on leveraged loans varies but a lower CSA on loans may squeeze ‘BB’ or lower-rated tranches.
APPENDIX 1. A sample bond total return calculation
Notes: The same return calculation can be replicated by using Bloomberg’s HTR function. ATSTC 2022-1A Class A start price at YE 22 and the end price on 6/30/2023 are assumed to be the same as the Palmer Square CLO AAA price. A 5% reinvestment rate in the holding period is based on the average of 3m SOFR rate in 2023. Data source: INTEX, Bloomberg, Santander US Capital Market LLC
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