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Structured Credit 

Sam Robinson

This article is part of our new service, 9fin Structured Credit, which will soon require a separate subscription to view. For more info on this product and the accompanying database, contact subscriptions@9fin.com

The festive season is upon us and it's clear that CLO market participants are expecting more. More CLOs exiting reinvestment, more pressure on the CLO arb squeezing equity investors, and more of a shift towards middle-market CLOs in the US.

But things could get quite choppy with many researchers foreseeing CLO spreads moving sharply from the first half of 2024 to the second. Although this is the consensus, there is difference of opinion with some foreseeing a widening trend as the year progresses, while others see spreads only getting tighter.

9fin has covered the predictions from seven CLO research and strategy teams and one of the key talking points is whether there will be enough issuance in 2024 to grow the market. The consensus is that issuance will be flattish year on year, but that's against the backdrop of a healthy amount of CLOs moving into their amortisation phase. 

There are doubts about whether the anticipated spread tightening will be enough to support a reset wave that will push out the CLO market’s reinvestment wall.

It’s not just CLO equity investors that people are anxiously scanning the horizon for. Researchers have been extensively covering the attraction (or otherwise) of the asset class for heavyweight triple-A investors such as US and Japanese banks.

Finally, a difficult macro environment (at least for the first half of 2024) has raised questions about what shape CLOs are in to weather downgrades and defaults. 

Outlined below are the key themes heading into 2024 — issuance predictions, the rise of middle-market CLOs, investors and demand, an asset-side outlook, and CLO performance metrics. 

In the US, issuance year-to-date stands at $85.5bn for BSL CLOs, according to 9fin data. Research desks predict that BSL issuance will stay flat or tail slightly in 2024, with forecasts sitting in a tight range of $70-85bn.

Morgan Stanley, on the more optimistic end with an $85bn prediction, has noted that non-economic incentives to print CLOs such as AUM growth and reputational risks, provide a “hard-to-quantify ‘soft floor’ on the amount of CLO issuance in any given year, which we would expect to continue in 2024”.

The research desks predicting lower levels of issuance cite the challenge of sourcing equity in a difficult arbitrage environment (more on this below).

Most forecasts see European new issuance staying at similar levels to 2023, where it stands at €25.7bn year-to-date.

Barclays predicts €20bn of new issuance, which is at the lower end of the spectrum. It cites somewhat higher default rate expectations and notes that “without a meaningful recovery in the EU CLO arb, we expect issuance to be limited mostly to managers with captive equity”.

Repricings, however, are expected to make something of a comeback. In Europe only four deals (all 2022 vintages) have been reset this year totalling €1.4bn, but in 2024 levels are generally expected to reach €7-10bn (with Bank of America suggesting they could go as high as €12bn), again chiefly coming from expensive 2022 deals.

Barclays anticipates more repricing activity in the US, as European CLOs have priced tighter historically due to the benefit of Euribor floors. The research notes that $57bn of US CLOs have triple-A spreads of 180bps or higher and are thus strong refinancing candidates.

Other desks have more cautious base case scenarios — Morgan Stanley predicts $30bn of refis and resets and Bank of America predicts €35bn in total.

Net, not just gross, issuance has become a topic of conversation with more and more CLOs coming out of reinvestment and starting to pay down, as well as an increase in liquidations.

Barclays, which has predicted $70bn of US BSL new issuance, warns the US market is at risk of shrinking in 2023, estimating a breakeven threshold of $72bn, split between $56bn of amortisation and $16bn in redemptions.

In Europe, amortisation has remained low despite WAL test breaches, and most desks see it staying that way. Morgan Stanley notes that amortisation rates vary drastically between CLOs, with some CLOs well past their reinvestment who have not yet begun paying down. 

Deutsche Bank’s Conor O’Toole notes that, despite 17% of European CLOs breaching WAL tests, “lots have not de-levered, even though supply has been mainly refinancings and A&E, so there’s been enough flexibility without WAL extensions, although some will take that option”.

One of the biggest stories of 2023 was the rise of middle-market (aka private-credit) CLOs in the US. For the previous five years MM CLOs have accounted for between 10 to 13% of US CLO new issuance, but in 2023 this rose to 23.5%.

Initially considered a blip during a low volume year, now all research desks covering the US foresee this trend gathering momentum in 2024. Estimates from researchers for the percentage of market share for MM CLOs range between 26 and 32%.

The consensus is that new issue volume will be at least $30bn, which would be an increase on the already record $26.2bn in 2023.

The growth of private credit in the US is a sign of a maturing investor base, said BNP Paribas’ David Nochimowski, where there’s been a rotation from BSL to MM from investors that like the spread basis, with more subordination.

This attraction is expected to diminish somewhat in 2024 despite the projected increase in supply. Citi says to “expect private credit spreads to tighten along with BSL CLOs in 2024 as more investors look for higher yields”, with the tightest triple-As potentially reaching 200bps by the end of Q1 2024.

Similarly Morgan Stanley predicts the 60-70bps basis between BSL and MM deals at the triple-A level will close slightly by the end of 2024 as the macro environment improves and investors become more familiar with the asset class and fuel demand.

Speculation on if, or when, we’ll see a European private-credit CLO has kept conference audiences entertained all year, and it seems that 2024 may finally bear fruit.

“We could see growth in the private credit CLO space in Europe, for the same reason we’ve seen growth in the US, the maturity wall and refinancing needs drives issuers to the private side,” said Nochimowski.

All CLO participants are eyeing the behaviour of investors at both ends of the capital structure going into 2024. Unfortunately for CLO managers, the outlook seems negative for at least one end of the stack, as no one seems to be holding out hope that third party equity will make a significant return next year.

Morgan Stanley thinks CLO supply will continue to rely on managers taking the equity down in the US, and in Europe it notes that resets will also require captive equity, while Barclays expects “global BSL CLO creation to be supported mostly by managers with captive equity”.

The other end of the equation is more complicated, with a variety of factors that may influence triple-A demand.

On the US bank side, Citi note that Basel III’s RWA proposal may have a positive impact on banks holding triple-As if implemented as proposed, as the risk-weight drops from 20% to 15%, although it wouldn’t fully come into effect until 2025.

Bank of America said Basel regulations favour floating rate products and “should drive increased participation in 2024”, but Morgan Stanley thinks “that any Basel clarity will take too long to make a significant impact in the next calendar year”.

Barclays has also noted the potential for bank demand to return in a small fashion due to a reversal in declining deposit trends, with deposits having stopped decreasing at the same time as US bank securities holdings have fallen to more expected levels based on pre-Covid growth rates.

Japanese bank demand should rely on the relative value of US dollar and euro hedged assets. Morgan Stanley states that hedging costs are at local highs, and whilst the possible end of NIRP (negative interest rate policy) could make domestic yields more attractive, “if the Bank of Japan is hiking whilst the Fed is cutting, yen will rise against the dollar and the FX-hedging costs for non-yen assets fall”.

Bank of America notes the same risk of cheapening domestic assets in Japan but highlights that hedged US CLOs triple-A offers are at a 30bps premium, and thus expect the demand trends to remain stable.

Numerous papers have highlighted the NAIC proposal which would make triple-As more attractive for insurance companies, although this would be accompanied by a falling away further down the stack.

Optimism over investor demand has fed into expectations of reasonable spread tightening in 2024, with predictions on triple-A spreads ranging from 150-160bps.

Outlooks have divided the year into half, with fed cuts expected to start in H2. Morgan Stanley notes that the “journey to slight tightening will be a little circuitous”, with spread movement in 2023 leaving little room for further compression and potentially difficult macro conditions eventually giving way to a smoother market.

Citi predicts that spreads will tighten to 150bps by the end of Q1, but notes the potential for some widening in the second half of the year when falling rates might draw demand away from floating rate products.

Deutsche Bank offers an even more bifurcated view, predicting “spreads will likely widen during the first half of the year and reach the mid-to-high 180s”, before retracing to 150bps by the end of the year.

In the US, leveraged loan supply is expected to increase for another year, although again this will be partially driven by refinancings and A&Es.

In Europe many 2025 and 2026 loans have already been refinanced or extended, but in the US the maturity wall is now coming into focus — Bank of America notes that 9% of loans now have maturities of less than two years, compared to 6% at the same point last year.

In Europe supply was dominated by A&Es in 2023 which, as mentioned, has helped with maturities, but the lack of new issue constrained supply for new CLO formation. (Look out for 9fin’s 2024 European LevFin Outlook coming soon.)

2024 may also see some dislocation in loan prices. 

In 2023 B3s have performed well, and Nochimowski expects this theme to reverse. “We’ll see decompression in 2024, with B3s and triple-Cs continuing to move further away [from higher-rated loans].” 

“This is because of the maturity wall and because in the new reality with CLOs out of reinvestment, CLOs will go and try buy high quality assets to manage WARF and WAL tests.”

Defaults are expected to increase next year in both the US and Europe, although rates in the latter are expected to remain lower thanks partially to the abundance of A&Es in 2023.

Default predictions for leveraged loans vary greatly depending on the metrics used, but when including distressed exchanges banks predict a range of defaults, from 3.25% (JP Morgan) to 5.5-6.5% (Barclays) in the US, although consensus is that 2024 will see the peak.

In Europe, projections are slightly more optimistic with banks predicting default rates of between 2.5% (Bank of America) and 4% (Deutsche Bank/Morgan Stanley).

In both cases these assume a somewhat ‘soft landing’ for global economies, and many highlight that more severe recessions would exacerbate these figures.

On top of the usual concerns for CLO investors and managers, the number of CLOs leaving reinvestment has been a big concern this year, an issue which looks set to continue in 2024.

The chief way to address this problem historically has been through resets, but the predicted spread tightening will not be enough to make a large amount of resets an economical option, say analysts.

JP Morgan is calling for a small uptick in refis and resets to $50bn in the US but notes it “remains generally expensive to reset a CLO and there are very limited refinancing candidates based on current market spreads”.

The other concern for CLO managers particularly in the US is elevated levels of triple-C assets in portfolios, a trend that is set to worsen in 2024. As covered in this month’s ‘Navigating the triple-Cs’, nearly 30% of US CLOs are tripping the 7.5% threshold, according to Barclays.

“For triple-C downgrades we think it will be gradual,” said BNP Paribas, “with the weaker ratings coming first. In the US triple-C buckets are at 6-7% but we could see it coming closer to 10%.”

“Elevated levels of B3-rated loans are a particular source of triple-C downgrade risk in our view [in Europe],” said Deutsche Bank. “As such, corporate rating downgrades across CLO portfolios in our minds present a key risk to deterioration in OC cushions.”

Away from triple-C tests though, CLO metrics are positive and should be enough for CLOs to withstand a rocky 2024.

In the US, Bank of America highlights that the share of loans marked under 80 has decreased slightly from 7% to 5%. JP Morgan notes that although OC cushions have dropped slightly from 4.15% to 3.58%, less than 3% of deals are failing their junior OC test.

JP Morgan has run stress test scenarios based on its default predictions – in the projected scenario of 3.25% defaults 23% of CLOs would fail a junior-OC test, but this would rise to 46% in the case of a bear-case 7% default rate.

2024 global CLO outlook — It's going to be a year of two halves

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