CLO outlook: value remains but watch for greed on pricing

Having been the best performing asset class across fixed income in 2023, collateralised loan obligations (CLOs) have spent the first half of this year on similar form with record levels of issuance meeting equally strong demand from a broadening range of investors.

Strong performance means prices have moved a long way year-to-date, and given we are seeing a high frequency of partial and full CLO repayments there will be several investors considering whether (or where) they should deploy their returned cash back into the market. This then seems a good opportunity to step back and think about where we see the market heading in the remainder of the year.

Let’s start with the primary markets. After 2023 was dominated by loan maturity extensions and limited M&A activity (a key driver for the supply of leveraged loans, the “raw material” in CLOs), expectations were for a relatively slow 2024 in terms of overall CLO supply. Instead, close to $90bn of US CLOs and over €25bn of European CLOs have been brought to market and welcomed by a wave of investor demand. As the risk of a hard landing has materially decreased and investor sentiment has improved, CLO spreads have tightened across the board in line with the broader fixed income market. This improved the economics for CLO deal sponsors and, aided by renewed Japanese demand for AAA bonds, the primary market gathered pace very quickly. The CLO-driven demand for leverage loans also gave many company CFOs the opportunity to renegotiate the spreads (and maturities) on their debt, resulting in a wave of loan repricings and prepayments. With more and more CLOs ending their reinvestment periods and recent deals coming out of their non-call periods, CLO managers have (as predicted) starting refinancing or even liquidating their CLOs at an increasing pace, leaving investors with some level of reinvestment risk.

Turning to performance, we can see lower rated bonds have outperformed by some margin YTD. AAA spreads have tightened by 20-40bp, BBBs by about 90bp and BB/B risk by a staggering 140-150bp in the secondary markets (for the latter that means a 12-15% YTD return already). In primary, spreads remain somewhat elevated in AAAs (Euribor+135bp) and BBs (625bp), though BBBs (325bp) have been pricing much closer to secondary levels. What has been encouraging to see recently is that in Europe, especially in BBBs and BBs, investors are now showing resistance to spreads going much lower. That in itself is interesting as while CLO spreads are now inside their 10-year averages, they are still some distance from their historical tights (unlike high yield corporate bonds) so in theory they do have more room to run. We don’t see a catalyst for CLO spreads getting closer to those tights very quickly, but AAAs in primary should tighten further from here as supplementary Japanese demand seems to be driving current supply. What we do see increasing is the degree of “tiering” between managers (and loan portfolios); especially in lower rated bonds, the spread between the best and worst managers can be as much as 200bp in secondary and 75bp in primary, so it’s worth doing your homework on which represent the best value for the risk.

What hasn’t changed is how CLOs have outperformed corporate bonds from both a rating and default perspective. S&P released its 2023 CLO and loan rating and default transition study last week, showing that European CLOs outperformed US CLOs with zero defaults in Europe versus six in the US (all six had been downgraded to CCC/CC before). Nevertheless, total global sub-investment grade CLO defaults stood at 0.5% in 2023, compared to 3.7% in global sub-IG (aka high yield) corporate bonds. The difference is a result of the structural protections built into CLOs, and follows the trend that we’ve seen for the last 25 years, which contrary to popular belief also applied to defaults during the global financial crisis – as the chart below shows.
 

Source: S&P, 27 June 2024

So supply has picked up, performance has been great, and in addition secondary market liquidity has improved significantly. Where does that leave us?

With CLO spreads now at materially tighter (but still relatively cheap) levels, there is a danger of investors getting too greedy, and thus we prefer to be cautious. For us that means being stubborn on pricing – we don’t see a reason to chase risk here. Geopolitical risk has not gone away and we see volatility being elevated for longer, so we expect there will be enough opportunities across the rest of the year. And with loan spreads getting tighter and tighter, CLO managers could be tempted to “barbell” their portfolios to make the cost of equity work. This practice involves combining high quality loans with poorer quality loans to increase income, leaving the portfolio’s average risk looking similar but leaving investors in lower rated tranches (such as BBs) more exposed to the lower quality assets. It is something we witnessed in 2018 and we didn’t like it then either.

Does that mean we don’t see value in CLOs here? Not at all. We like the look of certain shorter maturity BB/B bonds at current levels, and AAA spreads at 135-140bp still look cheap for the risk. However, we do think there is a case for exercising some caution and therefore, instead of rushing to reinvest proceeds from CLOs amortising or being refinanced, we would prefer to reassess the state of the market after the summer and enjoy the carry on the rest of the portfolio in the meantime.