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Michelle D'Souza

CLO market participants gathered at the LSTA DealCatalyst Annual US CLO Industry conference in New York’s Marriott Marquis on 29 and 30 April where 9fin was lead media partner.

Ahead of the conference, our structured credit team interviewed Amir Vardi (CSAM), Adrian Marshall (Elmwood) and Arlene Shaw (Brightwood) on various topics.

We highlight nine key takeaways from the panels…

Almost every panel spoke about the impressive growth of CLO ETFs, as total AUM for these passed $10bn in April. That included over $1bn of inflows in the first three weeks of the month alone.

Around 85% of total holdings are in triple-As. This makes CLO ETFs, as a group, among the top 10 holders of CLO triple-As, according to one panelist. Should the pace of growth continue this year, they could easily be in the top five

In the short term, the incremental ETF buyer base is positive from a spread compression perspective

The market has yet to see flows in and out of CLO ETFs and the impact of that volatility on CLO spreads. When rates go lower, the velocity of retail money could go out of these funds quicker

Comparison was made to historical outflows in the loan market. Although this represented quite a small portion of the market, it caused meaningful volatility in prices in a compressed period of time

2. Triple-As: new investors and keeping up with amortisations

Fully syndicated transactions are more doable now due to the larger number of investors

In 2023, around 80% of deals had an anchor triple-A buyer (usually buying two-thirds of the tranche). In 2024, that number is closer to 20-25%, one panelist said

Banks buying triple As as part of their underwriting mandate has become more prevalent 

New incremental buyers has led to spread compression

More asset managers have shown interest in CLO triple-As. This adds to US banks coming back and more interest from Europe

Today’s most influential incremental buyers are traditional bond fund managers, said one panelist

Japan has been a constant buyer with some conditions, including higher par subordination, a focus on senior loans in documentation and need for earlier pre-sale reports (9fin reported on specific requirements last year).

There are about 30 Japanese investors in CLOs. Of those, around 25 are banks and five are insurance companies

Less than one third of those banks invest in Europe

Japanese hedging costs have become a point of concern, with the dollar/yen reaching close to ¥160

Triple-A investors are going to get a lot of principal repayments from called deals and amortisation, adding to the number of deals already this year

In a poll, 40% of the audience said triple-A paydowns would be between $40-60bn while a further 30% believed paydowns would be over $60bn.

The paydowns are due to higher equity NAVs with much more of the loan market trading above par. In addition, there are many seasoned deals. Payment dates also drive these technical dynamics, and lots of deals in April’s payment date cycle showed high triple-A factors

Investors are concerned about being able to keep their exposure flat, let alone grow the book. There have been about $50bn YTD in refi/resets. 

This causes tightening in the new issue market with investors chasing paper

An uptick in recent refis has been driven by money manager demand for short-dated triple-A deals (one- or two-year reinvestment)

Secondary market flows demonstrate that liquidity is sustainable

Spread duration for triple-A senior bonds on the shorter-dated structures is very low and the carry is attractive versus similarly rated and weighted average-life investments, one panelist said. The demand allows managers different options to refi or even issue a brand new shorter-dated transaction

Large banks are increasingly getting taken out of their exposure of 2017/2018 vintage deals, which frees them up to reallocate to fresh CLOs in size, if only to maintain their exposure.

There has been general spread tightening across the CLO capital structure and the market typically sees manager tiering narrow when spreads tighten.

Historically, there has been a 30bps plus basis for tier-one and tier-three triple-A paper. With the compression of spreads, this is 10bps

There is more value in tier-one paper because investors are not receiving those higher spreads from lower tiers

Staying in higher quality when spreads are tight makes sense, according to one panelist. This is especially important for an asset manager that cares about marks and liquidity

There is still dispersion between managers with clean portfolios and managers with weaker portfolios

But one investor was worried that resets are coming to the market with slightly “dinged up collateral pools” and those are pricing right on top of kind of clean and fresh new issue deals

Attractive entry point for smaller managers

The tighter spreads for tier-two and three managers have allowed a more palatable entry point for those managers to come to the market, which may otherwise have been on the sidelines or locked out of the markets, like summer 2023

One investor highlighted tier-two manager double-B spreads as an area to focus on with investors getting some excess equity in the deal, higher spread and lots of restricted language around the end of the investment period. That's going to result in the deal amortising faster than other deals in the market. The annual default rate for double-Bs is around 25bps, so it’s not necessary to have the best manager

Despite the record supply, secondary trading levels remain very well bid, with most tranches trading close to par and demonstrating “tremendous liquidity”

A lot of recent new issue bonds are hitting the secondary market almost immediately

There has been incremental interest in short duration equity profiles with a few control pieces available in April

Conversion rates are also higher: one panelist said the market typically saw 50% turnover for equity at the beginning of the year. In April, that was upwards of 70-80%

The nature of trading with speed execution means it's not practical to look at docs for every trade, especially if its only $3-4m clips. Looking at how tradable a manager’s paper has been, WAL tests and OC tests are trading shortcuts 

Value add for strategic positions: docs are important for post-reinvestment deals where the CLO can be called or reset. How payment dates operate (business days) and what the notice period for calls are can turn positive trades into negative trades. In addition, the ability to flush incremental proceeds out to equity even when a CLO is failing those tests.

Middle market paper that’s “reasonably priced” at auction has around four to five instant buyers with a 90 price handle

Greater variance on lower mezz, with the investor base getting comfortable with the more challenging underlying collateral

Traders are keen for middle-market CLO equity paper

While tier-four paper may be great for asset managers, traders say they are focused on liquidity so they can rotate their portfolios

Why are CLO traders leaving their jobs? Well, one panellist believed that’s because the job has changed slightly. A few years ago the main goals in trading were to generate revenue, but banks now place a lot of focus on predictable and stable returns

There are also more opportunities for CLO investors to pursue than historically has been the case

“Juicy” double-B bonds over the past two years presented competition to CLO equity tranches. It was possible to earn 12-13% yield at a price of 90 cents on the dollar

Today, on a relative basis and an absolute basis, CLO equity looks much better. Triple- As are 40bps tighter and double Bs, while still attractive, have seen current yields compress

Managers and banks are willing to give up fees and other economics to get third party equity investors involved, unlike 2021

Third-party equity was more prevalent at the start of the year with 2022 collateral and tight loan spreads. Sourcing new issue loan has been a struggle.

Insurance companies are looking for rating stability and are willing to pay a premium to invest in senior triple-Bs

Hedge funds are looking to play opportunistically in new issue junior triple-Bs that replicate what secondary provides in terms of convexity

Higher for longer is helpful for floating rate products, with higher coupons for CLO debt investors

Borrowers are looking to reprice quickly, bringing forward timelines

But higher for longer can be challenging for some of the borrowers. The market is observing some of the 2025 potential defaults coming through and defaulting even earlier

Most parts of the loan market have enough interest coverage

It’s not just debt investors that are benefiting from higher current coupons. CLO equity investors have been receiving higher quarterly cash flows the past few quarters

“If you take a typical CLO with $500m of assets, $450m debt and $50m of equity, the $500m of loans are paying higher rates with higher current SOFR rates. The $450m debt is also paying higher interest rates with the higher SOFR, but you have $50m excess coming in from the loan side that are paying the higher rates that flow directly to the equity,” said one panellist

Credit decisions made in transactions of older vintages may be compounded by the inability to refi or reset them, or adjust their liabilities given those decisions. There may be even greater dispersion of performance

OC triggers: some seasoned, shorter deals post-reinvestment that were already close to failing, have started to dip below or get shut off

There will no doubt be competition between the two markets, just like the loan and high yield market, but both are here to stay.

Sponsors may want certainty of execution, a PIK toggle, delayed draw tranches or other options so are willing to pay 200-250bps more for that

Direct lenders filled the gap. In some cases, the middle market is taking away very levered credits, with triple-B minus and triple-C credits travelling away from the CLO market and preventing some defaults

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