Collateralized loan obligations (CLOs)—investment structures that buy up leveraged loans and debt securities, package them into tranches with varying levels of risk and return, and sell them to investors—had minimal direct exposure to banks like Signature and SVB, but there were initial concerns that we could see contagion spread from these high-profile banking failures to other institutions.
Despite drops in share prices of some smaller US regional banks—which, historically, have been regular investors in CLOs—the impact of the banking fallout on the CLO space was minimal, with issuance of new CLOs proving resilient in the first quarter of 2023.
In the US, issuance of new CLOs was up about 30% year-on-year by the end of Q1 2023 at US$40.4 billion, according to Debtwire Par and was up 10% year-on-year in April 2023.
While new CLO issuance in Europe was less buoyant (down approximately a third year-on-year in Q1 2023, reaching €6.7 billion, with a similar level of decline in April), the fall in activity was far lower than the almost 60% year-on-year decline in new leveraged loan issuance.
The long-term track record of low CLO default rates across economic cycles and the steady performance of CLOs relative to the wider investment grade debt market as interest rates moved upwards in 2022 meant that institutional investors continued to support new CLO formation through the first quarter of 2023.
CLOs are designed to work through economic cycles. CLOs finance themselves by issuing floating rate notes and, likewise, the assets in which they invest have floating rates, which means CLOs already in the market have been able to sail through the changing interest rate environment. CLOs in reinvestment periods (timeframes agreed upon by investors during which CLOs can reinvest principal and interest proceeds generated from their underlying loan portfolios) have also had an opportunity to buy up discounted loans in the secondary loan market and boost returns.
Meanwhile, the emergence of exchange traded funds (ETFs) targeting CLOs has helped to spur issuance. The number of CLO ETFs has climbed from just two in 2020 to seven in 2023, and, according to Morningstar, it is estimated that CLO ETFs now hold approximately US$2.8 billion of assets under management.
Refinancing dries up
While new CLO issuance held up well in 2022 and CLO managers navigated the regional banking meltdown of Q1 2023 successfully, CLOs continue to face a slower period in the months ahead. The market for CLO refinancings (where CLO managers refinance existing CLO note with new CLO notes to obtain more favorable terms) has completely shut down since February 2022.
The dearth of refinancings is an issue for CLOs as they are intended to be quasi-permanent capital investment vehicles that aim to refinance perennially and operate as evergreen structures.
In stable markets, refinancing provides significant transaction volumes for managers, arranging banks and advisers, but with interest rates increasing, it has become more and more difficult for CLOs to secure refinancings at more favorable interest rates.
Squeezed spreads
An even more pressing concern is the impact of sustained inflation and high interest rates on CLOs and their returns.
CLOs are floating rate structures that track interest rate increases and have weathered initial rate hikes well, but over the long-term, ongoing interest rate hikes and inflation will have an affect on the market.
CLOs are designed to take advantage of the arbitrage between their own funding costs and the rates on the underlying loans that they purchase and parcel up. CLOs generate returns by taking advantage of the gap between their financing costs and the yields on the loans in which they invest.
As interest rates have climbed, this arbitrage has reduced. By the end of April 2023, it narrowed to just 2%—the lowest level since the pandemic lockdown, according to Citigroup figures reported by Bloomberg. This compares to a spread of 2.6% at the same time last year. In Europe, meanwhile, spreads have been in freefall, falling by 0.77% in one month to 2.5%, according to Bloomberg.
Forecasts that inflation in the US and Europe would start to tail off significantly in 2023 and ease the pressure on central banks to keep raising interest rates have not yet materialized, dampening prospects for the returns that CLOs can deliver.
Narrowing spreads and lower potential returns have started to weigh on new CLO issuance, with the institutions that normally invest in CLOs able to secure better returns from other products and in the secondary debt markets.
According to Bloomberg, it has been especially challenging for CLOs to find buyers for the riskier equity tranches of their structures, while demand for the safest AAA tranches has also been soft, adding further downward pressure on spreads.
Larger CLO managers have been able to sell CLOs against this backdrop by leaning on captive equity vehicles (funds set up by managers to buy the equity tranches in their own CLOs). However, not all managers will have these funds in place, which will limit the number of CLOs that can be formed.
Holding out for rate stabilization
While there is still room for CLOs to protect spreads by buying loans at low prices and captive equity vehicles will enable some managers to keep issuing new CLOs, the landscape for new CLO formation and CLO spreads is expected to remain challenging until inflation and interest rates stabilize.
Unlike the fall in spreads and disruption observed during the pandemic, there is currently less visibility on when the CLO market will bounce back.
CLO markets rallied strongly in 2020 and 2021 as vaccine rollouts progressed, but, in the current environment, there is not the same single trigger that will solve the challenges posed by inflation, interest rates and the wider geopolitical stability. CLO managers hope that interest rates will plateau by the summer, inflationary pressures will subside, and CLO spreads will start to widen in the second half of 2023.
