The latest insights on leveraged loans and their impact on CLOs

Last year was a volatile year for global markets but also one where economies performed better than expected. If we look at the leveraged loan market, last year was characterised by a surge in so-called amend and extend (A&E). Companies were able to extend their debt maturities, which meant refinancing risk, one potential driver of corporate defaults, faded away and materially reduced the near-term maturity wall. In fact, ~90% of the European leverage loan market now has maturities at 2026 and beyond.   

What we would like to highlight today is the latest trends emerging so far in 2024.

As we ended the year with a better economic outlook and improved risk sentiment, loans rallied in line with broader credit. The European leverage loan index (ELLI) increased to 97.2 from 96 in December. However, the average bid prices for B and BB rated loans are now 98.4 and 99.5, according to Barclays.

This resulted in a spike in the portion of the index trading above par at 17.5% (the highest figure since October 2021) and more importantly 56% of the market is now trading between 98 and 100. 

The broad-based rally opened a window for repricing supply both in Europe and the US. According to CreditSights, January was Europe’s busiest month for loan launches since 2021 with 31 borrowers coming to market to raise €21.1bn. Almost 60% of this was made up of repricings. In a repricing deal in practice the borrower resets the coupon on its debt lower on average by 40 to 50bps. It is considered a prepayment of existing debt as investors that don’t want to participate in the deal can get their money back at 100. So far this repricing activity has had a couple of implications for the CLO market, which can be positive or negative depending on where you invest in the capital structure.

The main positive impact for CLO debt investors is the acceleration in AAA tranche amortisation. Around a third of European CLOs had exited their reinvestment period. These CLOs have more restrictions around reinvesting the proceeds from prepayments and therefore it’s more likely to see these deals amortising their liabilities.

For AAA CLO investors this is great, they get repayments on their bonds, which they can reinvest in primary transactions. For mezzanine investors this also has a positive impact because as the AAAs amortise the overall capital structure becomes more expensive, the leverage in the deal decreases and therefore it’s more likely that the CLO gets called. And with a large part of the CLO market still trading at a discount to par there is room for capital gains. We already saw four CLOs liquidated in January and more notices on potential calls are coming out.

If you have bought BBs last year at 90 cash price you are looking at 10 points of potential upside. In addition to that, while the AAA tranches pay down, the credit support on the mezzanine tranches increases and rating agencies are likely to upgrade these tranches as a result leading to further price appreciation.

The other impact that loan repricings have had on CLOs (more so on the ones still in their reinvesting phase) is the downward pressure on the weighted average spread. Lower spreads on the assets side means lower returns for the CLO equity holder as liabilities remain stable. A 50bps reduction in spreads means a potential 5% reduction in equity returns. CLO managers would be expected to sell these lower-margin loans in favour of higher-margin loans, which usually imply lower quality. Therefore, one thing debt investors will have to monitor closely is the potential change in collateral quality. 

Overall, these trends have certainly contributed to the strong technical we are seeing in the CLO market. Bs and BBs spreads have tightened by 80 and > 100bps year-to-date and banks are expecting higher volume of resets and liquidations. We welcome these as debt investors, not only because we own discounted paper but also because CLOs are not perpetual vehicles and we have been pretty vocal over the years around this point with CLO managers. The downside could be higher reinvestment risk in the coming six to12 months, but regardless potential headwinds further demand will be freed up and will help keep spreads suppressed.