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Global credit funds & CLO's
January 2024 | Issue 261
Published in London & New York.
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February 2024 | Issue 261

Rates are moving lower, which makes CLO equity look better versus loans

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Gretchen Lam
Octagon Credit Investors
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The challenge for tranche investors is to source paper in sufficient size
The latest edition of The Last Tranche podcast talked to new Octagon CEO Gretchen Lam about triple A spreads, CLO redemptions and whether investing in third-party CLO equity makes sense again.
Tom Davidson: Congratulations on the new role. You stepped up less than a month ago, so it must have been an interesting start to the year for you.
Gretchen Lam: It sure was, but you know what? The loan market is up, the CLO engine is coming back, and it’s certainly a nice way to start the year.
TD: I think it’s worth taking a moment to celebrate your promotion as a step towards gender equality. We’re lucky enough in the CLO market to have a relatively large number of women in leadership positions, but I think a female CEO of any major asset manager is still worth commenting on. GL: Thank you. I feel fortunate to work with and learn from many brilliant colleagues and mentors over the years, both men and women, from inside and outside of Octagon.
It’s been surprising for me to have had folks coming and saying: “This is so cool. I can’t wait to go and tell my daughter.” While that’s lovely to hear, I look forward to the day when a woman being named CEO is an absolute non-event.
TD: Moving on to CLOs, I think the question we’re all asking is about the arb. As you know, triple A spreads are firmly in the 150s. With this movement in spreads, does CLO equity make sense again?
GL: I think it does. The market loves to point to day one arbitrage as the only indicator of whether CLO equity in the primary market makes sense or not. The reality is, it’s one of many indicators and drivers of returns for CLO equity investors. But CLO primary equity is attractive today in our view, both on an absolute basis and on a relative basis. Now first, of course, triple A spreads have moved tighter by 25 to 40bps from mid-2023, which even if you assume some future spread compression on the assets does improve the day one arb.
And second, just as importantly, it is more attractive on a relative basis because competing assets have moved up in price over the past six to twelve months. CLO equity, for example, purchased in the secondary market, has moved up quite a bit over the past six months. Today, it trades at an IRR of somewhere in the 14% range, which is about five percentage points tighter than in mid-2023. And that’s if you could actually source equity in the secondary market.
Double B CLO tranches, which had traded back mid last year at projected IRRs of 12% or more, have moved similarly tighter and now trade in some cases above par. Today we’re modelling yields of about 10% for CLO double B tranches.
On top of that, you also have an interest rate environment where much of the consensus points to a peak in rates. As you look forward, rates are likely moving lower, which will make CLO equity look better versus loans or CLO tranches.
TD: Octagon is well known for using third-party equity instead of captive equity. Is that a strategy you’re going to stick with?
GL: Yes. We have been fortunate to have developed relationships with CLO equity investors that have had a good experience purchasing our equity and have continued to do so over many years.
TD: Do you think triple A levels are sustainable or do folks need to move fast? GL: I think they are sustainable. We see a line to inside of 150 over the course of the year. That’s driven by strong technical support that we think will be the primary driver pushing triple As tighter.
First, we expect that many existing triple A holdings will be repaid. Those repayments will come in the form of just the amortization of post reinvestment period CLOs in the natural order of the CLO life. And that will cause existing triple A investors to see their portfolios shrink by USD 50+bn over the course of the year.
In addition, we’re likely to see many deals called or reset. I’ve seen everything from USD 10bn of likely calls up to USD 100bn of deals that are ripe for a call. On top of that, we could see USD 100bn of CLO resets over the course of the year.
Lastly, we are seeing increased demand for triple As. We’re seeing many buyers that have been on the sidelines for much of the past 12 to 18 months starting to come back. Domestic banks, insurance companies, large asset management firms, all of them have expressed renewed interest.
TD: Returning to the topic of alternatives to CLO equity, I was very interested to see how tight some of the double Bs have been pricing.
GL: Absolutely. We’re clearly into the low 600s in the primary market, and we’re tighter than that in the secondary market. CLO double B tranches have probably been the biggest competition for new CLO equity over the course of the last year, so CLO double Bs trading at tighter levels is impactful — as is the forward SOFR curve.
TD: How do you see the loan market rally going?
GL: On the one hand, loan prices moving up is good for existing CLOs. It’s good for CLO equity investors. But it does create a challenge for managers looking to source new CLOs.
Looking back to 2022 or 2023, if you wanted to source loans for a new CLO, the best strategy was to go into the secondary market and buy loan assets at a discount. Sometimes that was as low as 96 cents on the dollar on average, and you could do this quickly. Fast forward to 2024, and 35% of the loan market is now trading above par. The opportunity to source cheap loans in the secondary market is far more limited.
Most CLOs this year have modelled in 20% to 25% of assets being sourced in the primary market. That compares to a range of zero in the case of a print-and-sprint, to maybe 15% for a typical new issue model that came to market in 2022 or 2023. Ramping CLOs today will likely take a little longer than in recent years, especially with the primary loan issuance running at a more modest cadence.
TD: We’ve already talked about CLO redemptions, but how many calls are you expecting this year, and in what vintages?
GL: We certainly expect more CLO calls in 2024. In the first three weeks we’ve seen at least five loan BWICs related to called CLOs come to market.
We estimate that over 10% of outstanding CLOs are well positioned for a call today. Not all of those deals will be called, but many could be.
For CLO equity investors, making the decision to call a CLO is like getting up from the poker table. When a poker player cashes out, they’re saying they’d rather take the chips they have in front of them and go home, rather than continue to sit and see what future hands they might win.
It’s kind of the same with CLO equity. As NAVs have increased, that’s like increasing the pile of chips in front of the poker player. And as future distributions in a CLO decline due to loan prepayments, that means future winnings for the poker player are likely to decline as well.
Which deals will likely be called over the course of the year? I think it’s likely to be those deals where the NAVs are positive, of course, but also where the prospects for future distributions are declining. It is manageable to stay reinvested over the first six months post the reinvestment period, but after that, it becomes increasingly difficult. Therefore we would anticipate many of the deals that ended their reinvestment period in 2022 or even 2023 will have a future distribution profile that points to a call in the short term.
TD: For a lot of CLOs the equity investor is also the manager, so we may see some interesting dynamics.
GL: We certainly will. I think many of those managers have governors as to the reset versus the call decision. There’s a framework to guide that decision. But those managers that aren’t beholden to outside investors, or for whom the internal capital doesn’t have any strings attached, will be looking at how they maximise overall income as a manager, as opposed to maximising the IRR associated with that specific CLO.
TD: Which brings us back to the old days, where secondary investing was all about working out which deals will get called, and which deals won’t.
GL: Dust off the screeners, we’re back! I think that question is perhaps most interesting for single B investors, where given how thin that tranche can be, you’re either covered or you have a 20% recovery. For that tranche, I think the call versus not decision, or the reset versus not decision, is going to be most impactful.
TD: One final question. On the CLO investing side, what spots are you looking at this year?
GL: Prices are moving fast, but as an academic exercise double BBs continue to be very interesting on a relative value basis.
I think CLO equity is also interesting. The challenge for 2024 for many tranche investors is, what is your ability to source that paper in size? We have been focused over the last couple of years mostly in the secondary market, both because we could easily source paper and also because we felt that was most attractive on a relative basis. We have shifted our focus to the primary market for both of those reasons.
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