Share this report:
Global credit funds & CLO's
January 2024 | Issue 261
Published in London & New York.
Copyright Creditflux. All rights reserved. Check our Privacy Policy and our Terms of Use.
January 2024 | Issue 261
Analysis
CLOs
Ask the market where spreads are heading
Poh-Heng Tan
Despite much talk about the poor arb, the metric for new-issue US CLOs has not changed greatly during the past two years. Does this mean the market is more efficient than we think?
Nothing brings the CLO market together like a good moan about the state of the arb. But according to our data, the arbitrage for new-issue US CLOs has remained in the same range for years. What does change is the activity in the market. In other words, the CLO market has become remarkably good at balancing supply and demand to keep performance consistent.
1: US BSL CLO new issue top-tier arbitrage (bps)
Source for charts: Pitchbook LCD, CLO Research
Priced to perfection...
In chart 1 (above), the loan index’s moving four-week average discounted spreads are used as a proxy for US BSL CLO portfolios’ discounted spreads. Arbitrage refers to the index’s discounted spread net of the cost of funding, based on discount margins (of triple A–BB tranches) rather than spreads. New issue upfront costs and management fees are not accounted for.
This chart shows that, despite ongoing discussions about poor arb in the new issue market, US BSL CLO new issue arb for top tier managers has remained fairly consistent. Perhaps the mentions of poor arb primarily refer to the better risk-return profile of lower-mezz tranches over equity tranches in a high interest-rate environment, but that’s a topic for another day.
As of 26 January, the latest CLO arb metric stood at 220.3bps, consistent with the median metric for 2023 (see table 1, right).
…by keeping issuance under control
Even if the arbitrage remains consistent across a range of conditions, that doesn’t mean CLO issuance doesn’t change. In fact, pricing a CLO deal has proven more straightforward when the loan market is robust and stable. As illustrated in chart 2 (right) approximately 75% of US CLO deals were priced when the Morningstar LSTA US B-BB Ratings Loan Index’s bid price was 97 or above.
When the market weakens, the new issue loan supply drops, and the CLO debt and equity investor base typically contracts. Market participants then grow cautious, often opting to remain on the sidelines. Arbitrage may also become more challenging, as it takes time for the market to re-balance. Generally, assets tend to move first, with liabilities adjusting accordingly.
The capital-raising environment also becomes challenging. Those with dry powder often benefit — deals with outsized returns were generally priced during periods of market volatility.
When market technicals are strong, and investors have confidence, more CLOs are priced. At these times, primary CLO equity investors may accept a lower target return or use a more optimistic set of assumptions in their modelling. For example, in 2014, 2018 and 2021, market conditions were strong, with an average loan price of over 99. As a result, 2014 was a record year for CLO issuance — a record which was surpassed in 2018 and again in 2021.
If the loan market strengthens, triple A paper could tighten to 134bps
You may think this bodes well for US issuance volumes for 2024. But even though loan prices are high, it is not straightforward to extrapolate primary issuance. One of the most challenging pieces of the equation today is the availability of CLO equity capital, which could be increased by:
- CLO liability spreads tightening faster than asset spreads
- relaxation of rating methodologies by rating agencies
- concessions from managers, arrangers, and others to reduce costs.
So where will triple A spreads go?
As we discussed above, the arb for US CLOs has been remarkably consistent. One key determinant is CLO triple A spreads.
Back in January 2023, the CLO industry pondered where new-issue US CLO triple A spreads would land by the end of 2023. We have the answer now. At the end of the year, the top-tier new-issue US CLO triple A tranche was printed at 160bps. This compares to the four-week moving average spread-to-maturity of the Morningstar LSTA US B/BB Ratings Loan Index, which was at 429bps.
Coincidentally, or not, when we looked at a sample of deals from 2012 to 2022 managed by 18 tier-one US CLO managers**, an average triple A print of 161bps was observed. This average coincided with periods when the four-week moving average spread-to-maturity of the loan index fluctuated between 420bps and 450bps.
The significance of this observation is that the 2023 year-end 160bps print (by CIFC Funding 2023-III) aligns closely with historical pricing trends, indicating a consistent pattern in the CLO market.
2: US CLO issuance by loan price
Looking ahead, how will new issue CLO triple A spreads evolve? The data suggests the answer to that question lies in US loan prices. Table 2 presents projected US CLO triple A spreads under various loan index spread scenarios, again based on our sample of 516 deals managed by 18 tier-one US BSL CLO managers.
If the loan market continues to strengthen, and the index’s loan spread tightens to the 330-360bps range, then top-tier US CLO triple A paper could further tighten from the 2023 year-end level, to as low as 134bps. Conversely, if loans weaken and the spread widens to the 480-510bps range, then top-tier triple A might widen to around 182bps.
In late January 2024, OHA Credit Funding 17, managed by Oak Hill Advisors, achieved a triple A print of 148bps, marking the tightest level since May 2022. This achievement can be attributed to the manager’s solid alpha-generating investment performance track record, its tier-one status, and the strong demand for CLO triple A paper.
While 148bps was solid at the time of pricing, the corresponding four-week Morningstar LSTA US B/BB Ratings Loan Index’s moving average loan spread was also tight, at 409bps. This indicates that the 148bps is in alignment with historical pricing trends.
Thus, the current tight prints for tier-one managers do not seem to result from an unusual imbalance of demand and supply, nor from the presence of aggressive triple A control buyers. Instead, they reflect conditions in the loan market.
** Managers in the sample are AGL, Ares, Barings, BlackRock, Blackstone, Carlyle, CIFC, CSAM, CVC, Elmwood, GoldenTree, Invesco, NB, NYL, Oak Hill, Octagon, PGIM and Redding Ridge.
Share this article:
