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The views expressed are those of the authors at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only.
In our July 2022 blog post, Don’t be surprised if CLO equity surprises to the upside, we expressed a highly constructive outlook for collateralized loan obligation (CLO) equity capital deployment over the coming years. Fast forward to now: We believe the disruptions occurring across financial markets, particularly within an otherwise healthy CLO market, further support this view and lay the groundwork for potentially higher internal rates of return (IRRs).
CLO equity is currently battling several near-term headwinds that we believe will prove transitory, giving us growing conviction that returns should improve in 2023 and beyond on the strength of three potential tailwinds: 1) improving liability costs; 2) resilient fundamentals; and 3) attractive bank loan spread entry points.
Ongoing monetary policy tightening by the US Federal Reserve (Fed) has raised borrowing costs, with the aim of tightening financial conditions to rein in persistent inflation. As a consequence, spreads across a number of credit sectors have widened sharply.
Credit spreads on AAA rated CLO liabilities have risen to over 220 basis points (bps) as of this writing, which is at the 96% percentile relative to history.1 I believe these elevated levels are due to temporary supply/demand imbalances and not structural or credit headwinds. These stiff CLO financing costs are challenging the equity arbitrage (“arb”) and slowing new CLO issuance over the near term, as financing costs have risen by a greater magnitude than bank loan spreads. In my view, CLO liability costs have significantly overshot and should normalize over the next 12 – 18 months as the Fed’s rate-hiking cycle concludes. (At last check, market pricing of the final hike was during the first quarter of 2023.)
The bank loan market is coming off a period of historically strong credit performance, including default rates of less than 1%, according to Leveraged Commentary & Data. My view is that defaults will increase from current low levels closer to their historical average range of 3% – 4%, peaking over the coming 12 – 18 months. Even within the context of potentially higher defaults, there are three reasons I think the current credit cycle is healthy:
Taken together, I expect there to be heightened spread volatility as the market digests the path of future defaults, but the absolute level of likely defaults appears manageable and consistent with historical default cycles in which the CLO asset class has performed well.
Bank loan investors are generally compensated for default risk through correspondingly higher credit spreads and an illiquidity premium. Bank loan spreads ended September at 665 bps, in the 86% percentile historically.2 To put that in the context of expected defaults, this level of spreads implies a five-year cumulative default rate of 49%, which is almost twice as high as the worst five-year default experience since 1990 (27%).
In my view, market illiquidity is driving spreads and income to draconian levels, creating what I anticipate will be a favorable environment for capital deployment in the loan market over the next 12 – 18 months. This may present opportunities for skilled credit selection to potentially drive enhanced returns.
While the arb today is challenged due to higher liability costs, we believe the combination of lower liability costs going forward, benign default risk relative to history, and lofty bank loan spreads offers an attractive opportunity for investors to deploy capital into CLO equity over the coming years.
These factors should provide an attractive income profile for the asset class in the near term and upside potential through refinancing/reset and active reinvestment against a backdrop of heightened credit spread volatility over the intermediate term. Thus, we would encourage investors to look through the near-term “noise” and focus on the return opportunity that may be available to patient capital allocators.
1Source: Wellington Management, based on historical AAA new issuance. Historical spread analysis based on trailing 10 years of month-end spreads as of 30 September 2022. | 2Source: Morningstar Leveraged Loan Index. Historical spread analysis based on trailing 20 years of month-end discount margin, three-year average life.
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