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Opinion CLOs
CLO structures provide insulation from changing interest rates
by Thomas Majewski
Thomas Majewski
Founder & managing partner
Eagle Point Credit Management
Rate cuts won’t hurt CLO equity cashflows — and may even boost them
After starting the year with some experts forecasting half a dozen Fed rate cuts, 2024 now has just a few months to run and markets are only now getting close to the first short-term interest rate cut.
As rates rose, many investors were worried companies might not be able to service their debt. But nearly all companies did. Now, with rates poised to fall, some investors are worried about the impact of rate cuts on CLO equity cashflows. But in our view, the change in rates isn’t really a big deal on the way up or down for CLO equity.
Looking only at changes in interest rates in simplistic hypotheticals, one could easily think CLO equity would be materially affected by rate cuts. Some cite the fact that CLO equity is typically 10 times levered and, in theory, the slightest move in rates could have a big impact when amplified by leverage. The reality, which few appreciate, is that the vast majority of ongoing CLO equity cashflows are driven by the difference in asset and liability spreads in a CLO, not SOFR. As a result, for CLO equity investors, while rates are interesting to watch, changes don’t really move the dial.
As most readers are surely aware, the forward curve already points to lower interest rates over the next few years. We recently studied the impact of an immediate additional 100 basis point downward shift in the forward curve on a recent CLO equity investment we made. The impact on the equity IRR was 40bps. Considering the multitude of things that can impact CLO equity (favourably or unfavourably), this is small potatoes.
We don’t like to give up 40bps of return. However, of all the risks we face, this investment is only 0.4x the market change in rate — despite being 10 times levered.
This analysis holds if all else is constant. (Ceteris paribus, for economics geeks like me.) The reality is that rate cuts provide other benefits.
Falling rates boost loan issuers
First, most broadly syndicated loan borrowers — the underlying collateral in CLOs — have large floating rate capital structures that benefit from cuts in rates. As rates fall, a reduction in interest costs should provide an additional cushion for loan issuers going forward — it’s easier to make your payments when they’re falling. Improved cashflow performance among CLO borrowers should lead to lower defaults, fewer downgrades and less negative loan modification and exchanges.
Secondly, the leveraged loan market hasn’t grown that much over the past few years as higher rates have slowed M&A activity by private equity sponsors. A driver of this trend is the high cost — which is due to high base rates — for private equity firms to undertake leveraged buyouts or other similar financings. As these financing costs ebb with lower rates, we expect to see an increase in M&A — and primary loan issuance. This should be a positive force for CLO issuance, helping alleviate the supply/demand imbalance that has contributed to spread compression in CLOs.
For CLO equity, that could also mean an ability to run more portfolios with lower cash to negative cash balances, which may improve equity payments overall. Also, the additional excess spread provides CLO equity with a boost in ongoing cashflows and more subordination to CLO debt should anything go wrong.
Bond gains enhance CLO returns
Thirdly, for CLO collateral managers that use their bond buckets, the price of many of those securities will rise as rates fall. Bonds purchased at discounts can be sold for gains and the proceeds reinvested into floating rate loans. This is one of the benefits of having a bond bucket in CLOs.
Of course, the Federal Reserve’s actions on interest rates will have a substantial effect on the broader economy that can be difficult to foresee. Rate cuts could potentially create other headwinds, such as reduced demand for leveraged loans from yield-hungry investors, or a further compression of loan spreads that squeezes CLO arbitrage. That being said, reduced demand from crossover high yield buyers may create buying opportunities for CLO collateral managers at better yields than the current market opportunity, so it does seem that even potential negative forces can have positive counterweights.
In our view, CLO equity is positioned well to outperform other areas of credit, even in the face of a declining rate environment. The structural features and cashflow dynamics of CLOs provide an insulation that we believe will allow the asset class to weather this changing rate environment. And the one after that.