The US collateralized loan obligation (CLO) market enjoyed a banner year in 2021 as a combination of Federal Reserve stimulus and investor focus on yield pushed issuance to record levels.
According to Debtwire Par, the issuance of new CLOs in the US more than doubled year-on-year, coming in at US$184.4 billion. Refinancing and reset issuance posted significant gains too, with refinancing climbing from US$21.2 billion in 2020 to US$111.8 billion in 2021, while resets jumped from US$10.6 billion to US$125.8 billion during the same period.
The unprecedented levels of CLO activity proved a major contributor to the tightening loan pricing backdrop observed through the course of the year. Ravenous appetite and competition among CLOs helped to drive average margins on first lien institutional loans down to 3.62%, compared with 3.73% in 2020.
Returns and resilience
Bank of America figures quoted by The Wall Street Journal highlight why CLOs have been so attractive to investors. While US Treasury Bonds and investment grade corporate bonds have delivered total returns of -1.82% and -0.96% respectively, Triple-A rated CLOs made gains of 1.4%. Double-B rated CLOs, meanwhile, made returns of 8.9% last year, outpacing both high yield bond and leveraged loan returns by significant margins.
This strong performance has seen large institutional investors—including the State of Michigan Investment Board, the Rhode Island State Investment Board and the Teacher Retirement System of Texas—increase their CLO allocations.
As investors have poured capital into CLOs, the market has become the biggest securitized credit sector in the US, with US$850 billion outstanding, according to Bank of America. This makes CLOs larger than other securitized debt products including auto loans, credit card balances and student loans.
CLO structures have also proven resilient. Unlike collateralized debt obligations (CDOs), CLO structures held up well in the stress of the 2008 global financial crisis and at the height of the COVID-19-related market downturn in 2020.
In a study of more than 2,200 CLO deals between 1997 and 2021, researchers from the Federal Reserve Bank of Philadelphia and the Wharton School of Business at the University of Pennsylvania found that the equity tranches of CLOs—tranches that receive additional cash flows after the coupons and principals of the loan tranches in the structure have been settled—showed resilience to market volatility. CLO debt tranches, meanwhile, show superior risk adjusted returns to similarly rated corporate bonds.
Through the pandemic, CLOs also benefitted from the low default rates (0.6% according to Fitch) among the underlying leveraged loans in which they invest.
Inflation drives further inflows
Momentum behind CLOs is expected to carry into 2022, with Morgan Stanley forecasting that new CLO issuance will reach US$160 billion this year. If achieved, this will make 2022 the second-highest year for annual CLO issuance on record.
Rising inflation and an anticipated interest rate rise by the Federal Reserve in March is expected to stoke appetite for CLO securities, as the leveraged loans bought by CLOs have floating rates that increase in line with rising interest rates.
The expansion of CLO strategies into new areas such as project finance and real estate could also spur activity. CLOs investing outside of the leveraged loan space have been rare, historically, but with the passing of the US$1.2 trillion US infrastructure bill at the end of 2021, managers have identified opportunities to diversify into project and infrastructure loans.
Early movers include Starwood Property Trust, which is believed to be the first US issuer of a CLO that will buy project and infrastructure loans. There is scope for infrastructure CLO interest to continue building, although the product is still nascent, and it will take time for investors and ratings agencies to build their comfort level and understanding of the offer.
One factor that could put the brakes on the otherwise upbeat expectations for CLO activity in the next 12 months is the transition away from the LIBOR interest rate benchmark to the new SOFR metric in the US.
LIBOR was phased out for new deals from the start of 2022, although CLOs and leveraged loan issuers continued to price deals off LIBOR until the end of 2021 and will be able to continue referencing the rate until the end of 2023. According to The Wall Street Journal, the challenge for CLOs is that, as the benchmark has switched over to SOFR, CLO asset pools could end up with loans using different benchmarks. This is problematic for investors, as it makes it more difficult to shield their CLO investments from shifts in interest rates and loan prices.
The CLO market is still adapting to the new benchmark but, as more SOFR-linked deals are done, CLO managers may look to mitigate risk by parceling assets into legacy LIBOR and new SOFR buckets.
As more SOFR deals hit the market in 2022 and the SOFR transition period passes, expectations are that CLO activity will pick up from where it left off in 2021.