A viewpoint on CLO markets: past, present, and future
Himani Trivedi, head of structured credit at Nuveen, shares her thoughts on the current state of the CLO markets, a lookback to 2022, and a view of what the coming year holds for CLOs.
Q: Last year was a challenging year for markets across the board, as geopolitical events, rising interest rates, and general investor skittishness sparked unprecedented levels of volatility. Tell us how the credit markets, particularly bank loans and CLOs, fared amid the broader turbulence.
A: In January 2022, credit markets started the year strong. Based on the Fed’s “transitory inflation” belief, most market-watchers expected the year to be a reprise of 2021, with a positive tone lasting at least until the middle of the year.
However, market sentiment quickly soured. Inflation took hold, and the Fed pivoted to a more hawkish bias, raising rates and telegraphing their intentions for an extended, data-driven rate hike plan. The Russia-Ukraine conflict further increased risk premia and overall volatility levels, leading to a domino effect in which equity markets sold off, followed by weakness in higher-beta credit markets such as high yield bonds. Wider spread levels percolated over to the bank loan and CLO markets where the cost of financing increased rapidly. Amid higher borrowing costs and anemic demand, new bank loan issuance came to a standstill.
Despite these headwinds, new CLO issuance continued at a decent pace for the first half of 2022. Issuance eventually slowed down significantly in the second half primarily due to the proliferation of underwater CLO warehouses, which negatively affected the economics for potential CLO equity investors.1 From our perspective, this created a window of opportunity to ramp up new CLO warehouses by buying discounted loans in the secondary market. We pivoted from a “borrow low, lend high” approach to more of a “pull to par” strategy for generating returns. Although CLO borrowing rates became significantly higher – eroding the available cash flow arbitrage for CLOs – we still saw an opportunity to target a mid- to high-teens return profile. We bought high-quality loans at 95-96 cents on the dollar with the goal of riding them back up to par on a levered basis. Although issuing new CLOs became more challenging, top-tier managers were still able to successfully bring new deals to market, and our platform was able to benefit from a loyal following of CLO debt investors which enabled us to access the market on attractive terms.
Q: Tell us a little more about the types of CLOs Nuveen issued in 2022. How did you adapt to a challenging and unpredictable market environment?
A: Last year’s CLO market highlighted two key themes: the dominance of well-established CLO managers, and the re-emergence of “print and sprint” deals (where CLO managers wait until after a CLO has priced before rapidly buying loans for the portfolio).
Throughout our ~20-year history creating CLOs, our investment philosophy has always followed a balanced approach. In general, we prefer that the market come to us rather than the reverse. We believe this disciplined approach allows us to stay nimble and opportunistic even in volatile markets.
We entered 2022 with dry powder and captive equity in the form of unramped pre-existing CLO warehouse facilities. We took a measured approach in using these warehouses and stayed focused on higher quality assets, which offered greater levels of liquidity. Ultimately, we launched seven CLOs during 2022. Most of these were print and sprint transactions where we looked for the best windows of opportunity to price our CLO liabilities and accumulate collateral. We spent the year continuously assessing the markets and staying disciplined, focused on only bringing deals to our investors that made sense. Our broad and highly integrated leveraged finance platform, which looks across bank loans, high yield bonds, CLOs, and related securitized assets, gives us a good sense of relative value and enables us to optimize our primary issuance.
Another dynamic we focused on in 2022 was convexity; specifically, our ability to target greater return upside by refinancing our CLO liabilities after the initial non-call period. With a widening in CLO debt spreads, we wanted to preserve the ability to potentially refinance deals at tighter spread levels when market conditions improved. With this in mind, we focused on issuing shorter-dated transactions to supply greater optionality and positive convexity for our equity investors.
Q: What factors are driving the lower projected CLO equity returns for new deals??
A: CLO equity returns, as modeled at the time of issuance, are basically “point in time” estimates under base case assumptions. While useful for setting a basic yardstick return profile, reality never follows the exact same path suggested by this analysis. Given the discounted purchase prices for loans in our 2022 CLOs, the modeled returns remained in the mid- to high teens, albeit with a different “path” to attractive returns based on pull-to-par rather than cash-on-cash distributions.
CLO structures are quite versatile. They are highly resilient due to the non-mark to market nature of the portfolio, and the debt that may be called and refinanced to take advantage of tightening credit spreads. This allows managers to augment returns by opportunistically refinancing the liability structure, alongside more traditional alpha levers such as disciplined underwriting, tactical trading, and maximizing post-default recoveries. In turn, CLOs provide access to a form of structural alpha which can boost return outcomes well beyond hypothetical modelled returns.
Q: How do you evaluate opportunities in CLO mezzanine debt?
A: Investment time horizon is a key consideration for CLO mezzanine investments. Some opportunities present themselves as short-term trades, versus others which should be evaluated as longer-term investment opportunities. In addition, opportunities sourced in the secondary markets present different trade-offs compared to primary-market purchases.
As an example, consider a BBB-rated CLO debt tranche trading at 95. During the fourth quarter of 2022, many of these instruments were yielding ~9% on an annualized basis. Beyond simply “clipping the coupon,” these securities also offered additional upside from price appreciation in an improving markets scenario and in the upside case, they could be repaid at par if tightening spreads made it attractive for CLOs to refinance their liabilities.
By contrast, BBB-rated CLO debt from newly issued deals in the fourth quarter offered higher coupons, albeit with less pull-to-par upside since these instruments were issued at or near par. In a scenario of improving markets and tightening spreads, these securities offered less upside relative to discounted BBBs on offer in the secondary markets. As a result, new-issue CLO arrangers were forced to offer investors higher coupons and structural sweeteners.
|Purchase Price||Coupon||Yield||3yr horizon2
TOTAL RETURN UPSIDE
|Hold to maturity
TOTAL RETURN UPSIDE
|Secondary purchase||95||L + 375||9.20%||8.60%||7.95%|
|Primary purchase||100||L + 450||10.50%||8.98%||8.84%|
One of the benefits of investing in CLO debt is that historical default rates have been extremely low, effectively providing an additional margin of error if the investment thesis does not pan out as planned. An investor may be anticipating an upside scenario of tightening spreads in the coming 2-3 years, but if the recovery takes longer than expected – or if loan market defaults rise higher due to a weakening economy – CLO debt is still likely to avoid losses, even in draconian scenarios. The resilience of the CLO structure is driven by tight covenants governing minimum credit quality levels, strict diversification guidelines, and various other bondholder-friendly guardrails to limit downside risk. This contrasts with corporate-debt instruments, where weaker covenant structures, idiosyncratic risk and other factors have significantly higher historical default and loss rates compared to CLO debt.
Q: How about opportunities in CLO equity issued by third-party managers? Are there similar trade-offs in the secondary versus primary markets?
A: Absolutely. As with CLO mezzanine debt opportunities, the investment time horizon is a key consideration when evaluating CLO equity, and the trade-offs between secondary and primary market opportunities are similar. However, CLO equity offers an additional, unique benefit which adds further complexity to the return story.
While CLO debt is effectively locked-in for the duration of the CLO, the underlying portfolio of bank loans may be reinvested at varying spread levels. This allows CLO equity to effectively offer a call option on widening credit spreads. When markets deteriorate and credit spreads widen, CLO equity can benefit, as the manager can either reinvest in 1) new-issue bank loans offered at higher coupon rates, or 2) bank loans trading in the secondary market at a discount to par. If the manager is skillful enough to avoid default-driven losses, CLO equity can capture more return upside in markets with widening credit spreads. This is one reason CLOs issued immediately prior to a default cycle have historically outperformed.
While this return dynamic predominantly affects older vintage CLO equity trading in the secondary markets, market volatility may also create opportunities in the new-issue space. During 2022, there were excellent opportunities to invest in print-and-sprint CLOs which accumulated cheap assets while retaining the ability to refinance liabilities in the short term. This approach added the benefit of scalability since secondary market volumes for equity tend to be sparse compared to primary-market opportunities.
Q: What are Nuveen’s predictions for new CLO issuance in 2023?
A: We have already seen a strong start to the year, with CLO markets bouncing back rapidly amid resurgent demand for CLO instruments. While CLO debt demand from U.S. banks is still weak due to regulatory, stress test-driven dynamics, interest from Japanese and European financial organizations has begun to recover. On the asset side, limited new loan issuance has been a headwind for CLO managers accumulating new portfolios, but continued outflows from retail loans fund have served as a meaningful offset, fueling new CLO formation. Indeed, year to date CLO issuance stands at $33.9 billion, despite net new loan issuance of only $14 billion (JP Morgan as of 3 Apr 2023).
Overall, we continue to see interest from investors at all levels of the CLO capital structure, which was not the case during most of 2022. However, we could quickly see a return to 2022 market dynamics, especially if the interplay between Fed moves and corporate earnings leads to risk-off sentiment among investors. We are positioning our portfolios accordingly, adopting a more cautious bias and searching for optimal entry points and compelling relative value opportunities. In this type of market environment, patience is key.
1 CLO warehouses consist of pools of bank loans which are purchased prior to the official launch of a CLO. When these bank loans fall in value after they have been purchased and before the launch of the CLO, the warehouse is considered to be "underwater". Since warehouses bank loans typically move into the CLO at cost, CLO investors are often reluctant to invest in CLOs with underwater warehouses.
2 Assumes that improved sentiment and tightening spreads lead to refinancing at par.
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