CLOs: 4 hot topics

We are coming off an interesting year for collateralized loan obligations (CLOs) in 2023, and we believe 2024 has a lot in store for investors. In 2023, CLOs were trading at historically high all-in yields due to a combination of elevated short-term cash rates and stubbornly wide spreads in the top quartile. CLOs were also indirectly impacted by the Silicon Valley Bank (SVB) collapse, as many banks paused their investment activities while the regulatory impacts were sorted out. The credit view also was murky, with many investors expecting a recession in 2023. Flip to 2024, and we are looking at a Federal Reserve easing cycle where all-in yields on CLO debt are likely to decline, an improved Basel risk weighting for banks to own CLOs, and a more sanguine outlook for the US economy. In this piece we share our views on what we believe could be the hot topics for CLO investors over the next 12 months.

Summary of our investment views: 

• Higher in the stack, we like both AAA and AA CLOs as high-quality alternatives to credit. However, investors need to consider their own views on the path of the Fed in terms of all-in yield.
• In the middle of the stack, we think the default remoteness of single-As makes them attractive. We are warier on BBBs, which could see downgrade pressure in this cycle.
• At the bottom of the stack, we selectively like BBs, but the collateral pool matters. In equity, we think this could be an outstanding year for new deal creation to lock in tight liabilities with the potential for higher credit spread volatility. 

4 hot topics

1. US bank demand: the 800-pound gorilla

US bank buying of AAA CLO tranches in 2023 was net negative US$4 billion, which was significantly below 2022 (+US$19 billion) and 2021 (+US$54 billion)¹ . All signs point to the trend reversing to net buying in 2024 for two primary reasons:

• Under the new Basel risk weights, the capital efficiency of AAA CLOs will improve from 20% risk weight to 15%.
• Duration has been in focus for banks after SVB, and the floating rate nature of CLOs potentially improve asset liability management with short-term deposits.

The reemergence of banks could provide a significant demand tailwind that has potential to reverberate down the capital stack. We are already seeing AAAs start to test local tights at the Secured Overnight Financing Rate plus 160 – 165, and many market participants are calling for a further tightening as 2024 progresses. We believe this can improve the CLO equity arbitrage, leading to new deal creation, and increase the ability for some older deals past their reinvestment period to be refinanced/reset.

2. Net supply: equity investors in seasoned deals facing new questions

A “new” phenomenon is emerging for equity investors: deal paydowns. After the global financial crisis (GFC), CLOs became perpetual capital structures, as the consistent tightening of liabilities allowed managers the optionality to reset their deal and extend its life. However, at the end of 2023, about 40%²  of all CLOs in the approximately US$1 trillion universe had exited the reinvestment period, and many of these deals are not economical to reset. This means that most deals will begin amortizing the debt tranches as principal pays down in the collateral pool. The equity investors in these pools face three options: 1) extend the deal through a reset by paying off existing debt tranches and issuing new tranches; 2) allow the deal to amortize until it becomes uneconomical; or 3) liquidate the loan pool and pay off debt.

The decision for equity on these three options is going to be deal-by-deal depending on their economics and incentives. Given the idiosyncrasies of each deal, and the low prepayment rates in loans, we do not expect a seismic shift in paydowns this year. However, we do expect this trend to take supply out of the market, creating a positive technical. This should present good opportunities for deals in their investment period, since these liquidations will come with the sale of loan collateral pools, which could widen loan spreads if the market cannot absorb the volume.

3. Private credit: is the end of the BSL near or is this a cyclical trend?

New broadly syndicated loan (BSL) supply has slowed over the past two years as volatility paused a lot of leveraged buyout (LBO) activity. The net supply of loans in 2023 was US$299 billion and US$245 billion in 2022, versus US$631 billion in 2021³ . Private credit swooped in at the opportunity and we saw several “cuspy” loans with a high risk of a CCC downgrade and/or default taken out by private credit lenders. Near-term, we view this as a positive, since these loans did not fit well into the CLO credit box, which tends to be higher quality. The emergence of a more flexible lender who can take on greater risk of default and can pay off a loan at par is a positive. Longer-term, we don’t view this as an existential threat to the public loan market. When LBOs return, the BSL market will need to remain a primary source of funding. 

4. Loan fundamentals: downgrades, defaults, and recoveries will still dominate

Many in the market, ourselves included, expected downgrades and defaults to be higher than they are today. Defaults for 2023 were around 1.5%, which is below the 20-year average of 2.1%⁴ . Borrowers have remained surprisingly resilient in the face of higher borrowing costs. We do believe higher defaults in a 2% – 3% range should be expected. This level of defaults is not an issue for the CLO structure, so we expect CCC downgrades to be the bigger headline story. There is a historically high level of B- loans in the market, particularly loans which were underwritten to B- in the boom years when leverage was cheap. As these loans migrate to CCC, there is a likelihood that seasoned deals will lose flexibility, as they will be dealing with managing themselves out of these positions. We think newer-vintage deals are in a better position given that they are being created with an expectation of higher defaults. Recoveries in the event of default will also remain in focus. Given the increase in loan-only (unitranche) structures, and easy lending standards post-GFC, we do expect recoveries to be lower than the long-term average of 70%. We are modeling closer to 50% – 60% as our base case. We think the low recoveries seen in 2023 are a function of the worst borrowers defaulting first, so we expect recoveries to be higher than what was experienced in 2023. 

¹Source: S&P, LCD, Nomura. Through November 2023. | ²Source: Baml research. | ³Source: J.P. Morgan, PitchBook Data, Inc, Lipper FMI. | ⁴Source: Morningstar/LSTA Leveraged Loan Index, par weighted defaults. Through November 2023.