The Big Idea

Out-of-consensus calls on CLOs in 2024

| November 17, 2023

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.

CLOs from the 2017 and 2018 vintages look likely to contribute some of the worse performing classes of CLO debt in the year ahead, often showing a high ‘CCC’ exposure, a thin junior overcollateralization cushion and lots of ‘B-‘ loans. Persistent high rates should keep particular pressure on those deals. ETFs backed by CLOs look like a bright spot, so retail investor appetite should grow.  And although the cash-on-cash returns to CLO equity currently look relatively low, new issuance may still manage to rise from current year levels.

Avoid 2017 and 2018 vintages

BSL CLO loan portfolios have seen more fallen angels than rising stars this year. S&P has downgraded 319 issuers of loans held by BSL CLOs through October but upgraded only 197. That leaves a downgrade-to-upgrade ratio of 1.6x. That ratio was 1.5x in 2022 and 0.52x in 2021. Downgrades of ‘B-‘ issuers to ‘CCC’ or below accounted for 15% of all rating actions (Exhibit 1).  Rising interest expenses and a plateau or decline in earnings should keep that trend in place.

Exhibit 1: BSL CLOs have seen a wave of issuer downgrades in 2023

Notes: Percentages are based on the count of issuers.  For example, S&P’s corporate rating actions in US BSL CLOs totaled 516 as of October 31, 2023, of which 75 were ‘B-‘ issuers downgraded to ‘CCC+’ or lower rated categories or 14.5% (=75/516).
Data source: S&P, Santander US Capital Markets LLC

A wave of ‘B-‘ downgrades to ‘CCC’ or below should put CLOs’ junior overcollateralization (OC) test cushion at risk of erosion. The average CLO today has 32% of its portfolio in ‘B-‘ loans and a junior OC test cushion of 3.5%. A subset of $79 billion in CLO deals have their junior OC test cushion lower than the average 3.5%, have exceeded their allowable ‘CCC’ exposure and have ‘B-‘ loan exposure already above the average 32% (Exhibit 2). This subset, or 181 CLOs, may be particularly vulnerable to ‘B-‘ downgrades given their high exposure to ‘CCC’ assets, low OC test cushion and larger ‘B-‘ loan share.

Exhibit 2: $79 billion or 181 CLOs with high ‘B-‘ loan exposure, low OC test cushion, and greater than 7.5% ‘CCC’ assets

Notes: The W.A. Junior OC test cushion and the W.A. ‘B-‘ loan exposure are calculated based on 1,832 or $843 billion BSL CLOs. Data on the histogram represents the number of deals in the ‘B-‘ loan exposure category.  For example, 120 CLOs have ‘CCC’ assets over 7.5%, junior OC test cushion below 3.5%, and ‘B-‘ loan exposure in between 32% to 37%.  Data excludes high-flex CLOs and CLOs with a collateral factor less than 0.1 that may have no outstanding bonds.  Junior OC test cushions are based on the ‘tier BB OC trigger cushion’ in INTEX.  The ‘B-‘ rating represents the minimum rating of loan assets in INTEX which takes the lowest rating reported by S&P, Moody’s, and Fitch. ‘CCC+ or lower’ loan exposure is based on S&P ratings.  The weights used in calculating w.a. ‘B-‘ loan exposure and junior OC test cushion are deals’ collateral par balance. CLO performance data were updated through November 8, 2023.
Source: INTEX, Santander US Capital Markets LLC.

A closer look at the $79 billion CLOs reveals that nearly 50% of CLOs in this group were issued in 2017 and 2018 and are largely in their post-reinvestment periods.  By contrast, some actively managed recent vintages, such as 2020 and 2022, have a much lower presence (Exhibit 3).

Exhibit 3: Some 2017 and 2018 vintage CLOs may perform worse than recent vintages

Source: INTEX, Santander US Capital Markets LLC.

Additionally, the 2023 vintage CLOs may benefit from recent credit trends in new loan issuance.  Year-to-date, the ‘B’ loan share in the new issuance declined to below 70% while the ‘BB’ share rose to 23%, giving CLO managers more choice in better loans (Exhibit 4).

Exhibit 4: ‘BB’ share in the new loan market has been on the rise in 2023

Notes: 2023 YTD data as of Oct 31, 2023.
Data source: LCD Pitchbook, Santander US Capital Markets LLC.

Retail investors may be the fastest-growing investor base in 2024

However, an increasing number of money managers have launched CLO ETFs to attract retail investors. CLO ETFs, despite their short history, have seen significant growth in 2023 (Exhibit 5).  Take Janus Henderson’s JAAA ETF, for example. The fund was established in October 2020, and its reported market cap was $378 million in 2021, $1.9 billion in 2022, and $4.7 billion as of November 10, 2023.  With CLOs’ total returns being strong in the past few years, inflows to CLO ETFs may continue.  Retail investors may remain a small share of the investor base, but they may likely be the fastest-growing sector by 2024.

Exhibit 5: The CLO ETF market has experienced significant growth in 2023

Note: *New ETF in 2023.
Source: Bloomberg, Santander US Capital Markets LLC

BSL CLO issuance may remain stable or rise in 2024

The BSL CLO arbitrage, using the difference between ‘B+/B’ loan spreads and the BSL CLO weighted average coupon as a proxy, has improved this year but remains below its historical average of 210 bp (Exhibit 6). BSL CLO issuance through the end of October trailed the same period in 2022 by 29% and the same period in 2021 by 45%. Leveraged loan and CLO debt spreads may leak wider next year under pressure from higher interest expense, rising downgrades and delinquencies and thinning structural protections. Despite all headwinds, BSL CLO issuance may remain steady in 2024 and likely exceed the volume of this year. Here are a few reasons that may lead to this possibility.

Exhibit 6: BSL CLO issuance declined with challenging arbitrage

Notes: CLO arbitrage = 3-mo moving average of ‘B+/B’ loan new issue spread – BSL CLO w.a. coupon cost.
The rolling 3-mo average CLO arbitrage from 2014 to 2022 averaged 210 bp compared to 160 bp in 2023.  2023 data as of Oct 31, 2023.
Source: LCD Pitchbook, Santander US Capital Markets LLC.

First, a rebound in corporate M&A and leveraged buyout activity could increase the size of BSL CLO deals. The average BSL CLO deal size so far this year is $424 million, low compared to recent years. A slowdown in corporate M&A and leveraged buyout activity this year has kept new loan issuance at bay. However, M&A and leveraged buyout activity could pick up in 2024 thanks to the rising hope that the Fed may engineer a soft landing and substantial amounts of dry powder held by private equity, sovereign funds and VC investors. A resurgence could be a challenge, however. My colleagues Dan Bruzzo and Meredith Contente point out elsewhere in this issue that global M&A volume measured in US dollars dropped 33% in 2023 to $3.01 trillion so far from $4.50 trillion in the previous year and is down 55% from a recent peak of $6.66 trillion in 2021. Even if there is some recovery, those M&A volume figures are likely to remain constrained in 2024 as materially higher rates present more challenging borrowing hurdles for potential growth opportunities within most corporate sectors.

The rolling last three months’ new institutional loan issuance totaled $75 billion through October.  Even with a modest 5% increase from this level, the average BSL CLO deal size may reach $450 million next year (Exhibit 7). At this deal size, the primary market only needs 200 BSL CLO deals to reach an annual volume of $90 billion, which is roughly the annualized volume of issuance this year. From 2014 to 2022, the average number of BSL CLO deals issued in the primary market each year was 214. If the BSL CLO arbitrage remains tight, of course, it may be hard to get to an average number of deals.

Exhibit 7: BSL CLO deal size has been strongly correlated with loan issuance volume

Notes: Data represents new institutional loan issuance volume and BSL CLO issuance volume from January 2020 to October 2023.  New institutional loan issuance from August to October 2023 was $75 billion and the average monthly CLO deal size in the same period was $422 million. A 5% assumption of loan volume increase may boost CLO average deal size to $450 million (= 0.4843 * 75*1.05+411.84).
Source: LCD Pitchbook, Santander US Capital Markets LLC
.

Second, small managers may continue issuing short CLOs next year. BSL CLO managers generally issue deals with a 5-year reinvestment and 2-year non-call period (5NC2).  Of the 32 managers who have issued BSL CLOs this year with no more than a 4-year reinvestment period, 14 have CLO AUMs of less than $5 billion (Exhibit 8).  While managers generally prefer to issue CLOs with a 5NC2 structure, the potential benefits of tighter spreads and better liquidity in the secondary from frequent issuance may encourage small managers to continue offering short deals to attract investors.

Exhibit 8: Small and new managers have issued most short CLOs this year

Notes: Data represent 32 managers issued short CLOs (<= 4-year reinvestment period) with an aggregate issuance of $15.6 billion. Static CLOs are not included.  2023 YTD data as of October 31, 2023.  Blackstone CLO AUM includes deals from Clover. Anchorage Capital CLO AUM does not include their CBO deals.
Source: LCD Pitchbook, INTEX, Santander US Capital Markets.

It is worth mentioning that in 2020 and 2022, loan market volatility contributed to the surge of short CLOs in the primary market.  Managers who issued short CLOs in those two years bought loan assets at low prices and expected market volatility to ease in a year or two, allowing them to refinance or reset their short CLOs to generate good returns.  This year, the leveraged loan daily price volatility dropped to a level comparable to 2018, but the short CLO share in the primary market has stayed elevated at 21% as compared to 9% in 2018 (Exhibit 9).

Exhibit 9: Loan market volatility eased, but short CLO issuance has stayed high this year

Notes: The standard deviation of the Morningstar LSTA US Leveraged Loan Index daily price in a year is calculated for leveraged loan price volatility.  Short CLOs are new issue BSL CLOs with reinvestment periods less than or equal to 4 years, including deals with 4NC2, 3NC2, 3NC1, and 2NC1 structures.  Static CLOs are excluded from the analysis. 2023 YTD data as of October 31, 2023.
Source: LCD Pitchbook, Bloomberg, Santander US Capital Markets LLC
.

The relatively high short CLO issuance this year may also reflect small managers’ pressure to exit aged warehouses.  Other tailwinds for the CLO primary market in 2024, as most market participants call for it, may include strong issuance momentum for middle market CLOs, captive equity funds raised by CLO managers and debut issuance from new managers.

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

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