It’s not just high interest rates that are helping CLOs outperform

Thomas Majewski

Founder & managing partner Eagle Point Credit Management

It is unlikely a well-capitalised sponsor would allow a growing portfolio company to default

For most traditional fixed income assets, the prospect of a ‘higher-for-longer’ macro environment has caused real pain. The increase in interest rates has led to depressed prices for fixed-rate instruments and a second year of negative returns for many bond investors.

But not all fixed income asset classes are having the same experience. Indeed, the higher-for-longer environment has overall been positive for senior secured loans and CLOs. Both markets are handsomely up for the year.

At first glance, senior secured loans’ floating-rate nature would seem to account for most of the outperformance, both from an interest-rate duration and a yield-generation perspective. This is certainly a key element, but resilient fundamentals among borrowers in the face of rising input costs are also a major part of what’s driving senior secured credit.

Defaults down despite interest rate hikes

Despite higher interest rates, loan issuers continue to grow their top lines and bottom lines. Last year, many media outlets claimed that 525 basis points of rate increases by the Fed would cripple loan issuers and lead to high default rates. While that may make a click-grabbing headline, in reality, the opposite occurred, with defaults remaining well below long-term averages. Indeed, no loan issuers defaulted in September, and the quarter ended with a trailing 12-month default rate roughly half the long-term average, according to Pitchbook LCD. Many loan issuers continue to grow their revenue and ebitda. In fact, according to JP Morgan, ebitda margins have increased in the second quarter, resulting in the highest margins in years.

By most accounts, US consumers have been resilient, and many of the expense adjustments companies made during the covid pandemic have remained. Together, this has allowed most companies to continue servicing their higher debt costs. Even if margins thin or maturities approach, as long as businesses are growing — like they are now — we should continue to see most loan issuers push out maturities and raise cash, as necessary.

With revenues and profit margins outrunning current economic challenges, the credit environment has remained favourable overall. September saw loan default rates decrease to a six-month low of 1.3%, well below the long-term average of 3%, according to Pitchbook LCD. Also, since the middle of this past summer, the ratio of loan issuer credit rating downgrades to that of upgrades has evened out, further indicating the asset class’s overall ability to absorb higher sustained interest rates.

Default rates are only part of the broader fundamental credit picture. Distress levels in US leveraged loans have also declined this year. Following the late summer rally in the secondary market, the rate of distressed issuers (those trading below 80% of par) in the overall market dipped to 4.7% by the end of September, according to Pitchbook LCD. While this is elevated by historical standards, it is down considerably from the 7.4% at the end of 2022.

Meanwhile, with private equity funds sitting on more than $2 trillion of dry powder, and relatively few attractive opportunities, we may begin observing private equity sponsors injecting capital into portfolio companies in order to help them navigate choppy markets. It is unlikely a well-capitalised sponsor would allow a portfolio company with a path for continued growth to default on its debt simply due to a tight debt-service coverage ratio. We view this as a strength for loans, which could lead to defaults remaining a fair bit lower than many pundits have feared.

Reinvestment options offer resilience

Clearly, CLOs have benefited from the outperformance of senior secured loans. Should headwinds arise for underlying issuers, we believe the ample overcollateralisation cushions and continued reinvestment options innate in CLO structures will provide resilience — keeping cashflows current and strong. Because CLOs benefit from the protection of investing high in the capital structure of typically multibillion-dollar companies, coupled with their reinvestment periods, the CLO asset class is well suited to navigate such periods of market stress — and to continue generating positive returns, regardless of the direction of rates.

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Global credit funds & CLO's

November 2023 | Issue 259

Published in London & New York.