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From where we sit, it’s shaping up to be an interesting environment for collateralized loan obligation (CLO) equity investors. On one hand, the equity arbitrage (a metric used to model returns) has been challenged by technical factors so far this year. On the other hand, increased credit market volatility can enhance potential upside for the asset class. And of course, we also have the looming impact on economic growth of the US Federal Reserve’s (Fed’s) interest-rate hiking cycle.
Against this evolving backdrop, there are three key factors we are closely monitoring to evaluate the relative attractiveness of CLO equity: 1) the current outlook for the equity arbitrage; 2) balancing upside potential in volatile markets; and 3) the state of bank loan fundamentals.
The CLO equity “arbitrage” (“arb”) is the difference between the term financing costs (i.e., CLO debt coupons) and the credit spread of the underlying bank loan pool. It’s an indication of the level of net income to expect from CLO equity at time of issuance.
Year-to-date 2022, the arb has deteriorated because financing costs have increased relatively more than bank loan spreads. In mid-April, the arbitrage reached 1.75%, near its low over the past five years. In our view, the main technical factor pushing financing costs wider is the Fed’s balance-sheet reduction process, which has squeezed big US banks’ demand for AAA rated bonds. In recent years, US banks have been the largest buyers of AAAs, which are the primary driver of the “all-in” financing cost to equity. We expect this technical pressure to ease in the coming quarters. In fact, there are two catalysts we are watching that could help improve financing costs:
The arb has already begun to correct and is now trading closer to 2.50%, which may translate to new issuance pricing with modeled CLO equity internal rates of return in the low to mid teens.
The returns to equity in the years ahead may be driven more by principal return vis-à-vis credit market volatility than by the arb at time of issuance. Assuming default rates are elevated but contained going forward (an important assumption), CLO equity may stand to benefit from credit market volatility in two ways:
These two scenarios create a long-volatility-like profile for the asset class in periods of market dislocations. This does not mean investors should ignore the arb, as an attractive arb is critical to earning stable income returns through a given cycle. However, if investors have conviction in a higher-volatility environment over the next 12 – 36 months, it may be worth assessing the arbitrage entry level against one’s views on the future paths of credit market volatility and bank loan fundamentals.
Our take is that now is an opportune time to add risk to the asset class, particularly amid the upside potential from credit spread volatility.
A crucial step in analyzing CLO equity is to form an outlook on bank loan fundamentals, specifically regarding the forward expectations for default rates.
As of this writing, we believe fundamentals in the bank loan market are likely to deteriorate from here on the back of higher interest rates and a slowing economy — with the caveat that fundamentals are starting from a very strong baseline, with record-low defaults, robust interest coverage, and plentiful corporate liquidity. We do think certain borrowers in the loan market will feel greater financial stress in the second half of 2022, so we are modeling in more punitive defaults and recoveries for select cohorts.
Even with deteriorating fundamentals, if defaults remain range-bound, we believe the high loan spreads associated with a recessionary environment will offer opportunities for credit selection to offset realized defaults (at least partially) in the collateral pool. Naturally, we would have a markedly different view if we anticipated entering a period of multiyear sustained defaults (above levels seen in 2001 – 2003 and during the 2008 global financial crisis).
In short, while it’s hard to pinpoint the best time to invest in CLO equity, we believe the asset class has real potential to be a standout investment relative to many other risk assets over the next few years.
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