CLOs: Poised to outperform in 2023?

Collateralized loan obligations (CLOs) are sparking investor interest given their attractive yields relative to other credit assets. They are also generating questions about exposure to below-investment-grade bank loans in a rising default environment. Here are our views on the fundamental and technical factors that we believe are important to assess when considering allocations to the CLO market in 2023. We also share our top actionable trade ideas: AAA-rated CLOs and CLO equity.

Fundamentals

Weakening bank loan fundamentals are expected in the period ahead, but CLO structures may offer investors a safe haven, particularly for senior noteholders.

As noted in our bank loan team’s 2023 outlook, we think default rates are likely to rise to between 3% and 4% in 2023, with the bigger story likely to be credit rating downgrades. However, we believe CLO performance will likely hold up in this environment, with the primary risk for rating-sensitive investors being potential downgrades in the mezzanine tranches.

CLO debt tranches higher up in the capital structure can endure a substantial pickup in defaults on underlying loan collateral before taking a principal loss. For a AAA CLO, roughly 85% of the loan pool (40% for BBBs) would need to default before we modeled principal losses to the tranche¹ ; this is well above the worst seven-year cumulative default rate for loans (26%). However, CLO debt — particularly lower-rated mezzanine tranches — may see greater ratings risk given our expectation for increased loan downgrades to CCC. This could lead to preemptive and/or forced selling in these tranches. 

For the equity tranche, we think investors are being well compensated for the expected default environment through elevated loan spreads. As of year-end, loan spreads of 532 basis points (bps) were pricing in breakeven cumulative defaults of 46% over the next five years² , which exceeds our modeled bear case scenario (27%). Absent a severe and sustained spike in defaults, this should create stability for arbitrage and provide CLO equity holders the opportunity to reinvest into wider loan spreads. 

Technicals

AAA buyers will probably be slow to return to the market, impacting CLO new issue supply for the first half of 2023.

AAA CLO spreads are likely to stay rangebound in the near term until some of the larger AAA investors return. Large US money center banks and overseas investors typically have driven demand for new issue AAAs. However, banks’ appetite for securities has waned as they attempt to repair their balance sheets. Meanwhile, increased hedging costs have made it less attractive for overseas investors to own AAA CLOs. Further, the recent move by the Bank of Japan to expand its 10-year yield target band is likely a net negative for Japanese bank demand, which could decrease marginal overseas buying in 2023.

Still, we believe these investors will return in 2023 as central bank rate-hiking cycles peak and the macro outlook comes into sharper focus, which would help support spreads. AAAs look attractive to most banks at these yield levels, given their preferred capital treatment. Eventual tightening in AAA spreads and resumed loan issuance should improve equity arbitrage, spurring new CLO creation from pent-up 2022 supply and creating an exit for outstanding warehouses. This demand “push-pull” for AAAs and new CLO supply could keep spreads rangebound, which seems healthy to us after a year of unhealthy technical imbalance.

Top implementation ideas

AAA-rated CLOs
With AAA CLOs yielding around 6.0% as of this writing, their valuations look compelling versus other credit sectors and relative to history. Attractive yields and “default remoteness” of AAA CLOs have gained the attention of clients seeking short-duration, high-quality, liquid alternatives for their excess cash. CLOs may provide some protection from rising rates (due to their lack of duration), while also benefiting as their floating-rate coupons reset higher. 

Potential risks are twofold: 1) AAA CLOs can exhibit price volatility, especially in times of stress, as their higher quality and liquidity make them a source of funds for raising cash; and 2) ultimate income realization may be lower than the prevailing yield if the floating reference rate declines and/or deals are called later when spreads normalize.

CLO equity
CLO equity looks poised to benefit from volatile credit spreads and historically elevated bank loan spreads, and it has historically outperformed other risk assets during periods of volatility. We believe these same structural factors are in place now. The equity tranche owns two options, which we think offer more value in 2023 than any recent period: 

1) If loan spreads are volatile but defaults remain in check, CLO equity can benefit from reinvesting collateral at wider spreads, boosting income/return. 

2) CLO equity owns the right to refinance CLO debt — a potentially valuable option with CLO debt spreads near historical wides as of year-end 2022. 

The risk case for CLO equity: A severe, drawn-out default cycle where equity principal is eroded and cashflows at risk of being diverted to senior noteholders. We expect the asset class to trade with equity-like price volatility, subject to potential drawdowns, and to offer low liquidity as the market assesses the economic path ahead. However, we think realized returns are likely to be attractive going forward.

¹Assuming a conservative recovery of 50% vs the long-term average of 70% | ²Based on spreads of J.P. Morgan Liquid Loan Index. We incorporate an assumption on recovery rates when computing the breakeven default rate implied by a given spread level. We base this calculation on the historical inverse relationship between default rates and recovery rates, using data from 1990 for first lien loans. We fit an exponential curve to the data (so that recovery rates can’t go negative) and use the resulting curve to pair a default assumption with an accompanying recovery assumption.