The Big Idea
Lessons learned from CLOs in 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.
Supply and demand mattered, as usual. It shaped loan prices and the CLO arbitrage. And access to new financing mattered especially for borrowers with maturities in coming years. For some, these are lessons learned. For others, important reminders.
Supply and demand matters
The outstanding leveraged loan market has gone through some ups and downs in the last few years with par balances rising into September 2022 before starting to fall and roughly stabilizing in February this year (Exhibit 1). Through November this year, new loan issuance totaled $226 billion with $221 billion in repayments—a net gain of only $5 billion.
Exhibit 1: The trailing 12-month loan market growth rate has turned negative this year
Data source: LCD Pitchbook, Santander US Capital Markets LLC.
Despite low net loan supply, CLO managers’ appetite for loans did not abate. The par balance of outstanding BSL CLO loan portfolios went from $860 billion at the start of the year to $914 billion through November for net growth of $54 billion.
Loan supply and demand dynamics almost certainly helped support loan prices this year. The leveraged loan index price reached $95.85 recently, a $3.41 gain from the beginning of the year. Higher loan prices have improved the market value overcollateralization (MVOC) ratios of many outstanding BSL CLOs, a measure of portfolio market value to outstanding debt. As a result, CLO secondary spreads have tightened from last year’s levels and are currently at their 2023 tights (Exhibit 2).
Exhibit 2: CLO secondary spreads have narrowed along with the rise in bonds MVOC
Notes: Data in the analysis include 1,747 outstanding BSL CLOs with an aggregate deal balance of $860 billion by 2022 end of year and $828 billion by Nov 2023. The median of 1,747 CLOs’ MVOC at each rating category was used in the analysis. Secondary spread levels are based on the Palmer Square indices.
Data source: INTEX, Bloomberg, Santander US Capital Markets LLC.
#2. Loan market dynamics keep the share of short CLOs in the primary market
The same supply and demand dynamics in the loan market, on the other hand, did not help CLO arbitrage. CLO arbitrage, measured as the difference between new first lien loan spreads and the average financing cost of new 5NC2 CLOs, has stayed around 150 bp this year. While CLO financing costs in the primary market generally trended down throughout the year, the strong demand in the loan market kept spreads tight (Exhibit 3).
Exhibit 3: CLO arbitrage has stayed difficult throughout the year
Data source: LCD Pitchbook, Santander US Capital Markets LLC
The headwinds in CLO arbitrage prompted some managers to keep issuing short CLOs, departing from the common 5NC2 structure.
In the primary market, a few managers printed short CLOs with spreads tighter than peer 5NC2 deals priced in the same month. But for most managers, this is not the case. However, a shorter non-call period or reinvestment period gives managers more flexibility to improve arbitrage if the refinance or reset options become available in the near future. By the end of November, the share of short CLOs represented 26% of the primary market issuance, compared to an annual median of 17% from 2018 to 2022 (Exhibit 4). If the arbitrage stays challenging, short CLOs may continue to help add primary market volume.
Exhibit 4: Short CLO issuance has been active this year
Notes: Non-5NC2 CLOs include deals with less than a five-year reinvestment period and two or shorter non-call periods, including static CLOs. BSL CLOs data only.
Data source: LCD Pitchbook, Santander US Capital Markets LLC.
Loan maturity wall indicates ‘B-‘ loan downgrade pressure for CLOs may persist
The maturity wall in the loan index by the end of November implies heavy refinance and amend-to-extend activity throughout the year. At the end of 2022, for example, $75 billion in loans had maturities scheduled for 2024, but today that balance is only $11 billion (Exhibit 5). The same pattern holds for loans with maturities originally scheduled for 2025. At the end of 2022, $198 billion had maturities in 2025, but today that stands at only $96 billion.
Exhibit 5: A large share of loans with maturity in 2024 and 2025 refinanced or extended
Data source: LCD Pitchbook, Santander US Capital Market LLC. YTD Data as of December 8, 2023
Most issuers who refinanced or extended their loans with 2024 maturities are rated ‘B/B+’or higher. For example, at the end of 2022, $34 billion of loans that would mature in 2024 were from ‘B/B+’ or higher-rated borrowers. By November this year, 94% of this group had either refinanced or extended maturity. By contrast, ‘B-‘ or lower-rated borrowers lagged.
If refinance or amend-to-extend options are not available to those ‘B-‘ or lower-rated issuers, their loans with 2024 and 2025 maturities are more likely to be under downgrade pressure. Given that $57 billion or 53% of loans with 2024 and 2025 maturities in the index today are from ‘B-‘ or lower-rated issuers, CLOs ‘CCC’ exposure may continue to rise next year.
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