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Charlie Dinning

9Questions is our Q&A series featuring key decision-makers in the corporate credit markets — get in touch if you know who we should be talking to!

Sourcing triple-A investors is always a major focus of CLO managers, but it's become especially acute over the past few months in the US market. 

Demand for this part of the capital stack has become pinched of late, so it's understandable that people are asking when that pressure is going to ease. To answer that question, we talked to Adrienne Butler, co-head of Barings US high yield and head of US CLO funds. 

She also touched upon the reinvestment crunch the CLO market is grappling with, how to manage low recovery rates from loan defaults and what the growth of private credit means for the broadly syndicated loan market..

1. With US banks less active in CLO triple-A buying this year, how is the market adapting to the changing dynamics of the asset class?

As the CLO market has expanded to over $1.3trn in size, the investor base has diversified. Japanese banks and insurance companies stepped in to cover a portion of the triple-A demand as the large US bank demand has waned over the last 18 months. However, there have been rumblings at recent industry conferences that US banks may become more active again, although the timing of their return is uncertain. 

Additionally, the current Basel proposal drops the RWA to 15% from 20%, which could help incentivize bank demand in triple-A CLO tranches going forward. These shifting demand technicals have led to ebbs and flows in the refi and reset market, with short non-call deals issued in 2022 becoming more attractive as spreads come in off historic wides. 

The lesser triple-A demand has also made sourcing third-party equity somewhat challenging.

2. What does the growth of private credit mean for the leveraged loan market, as private credit transactions get larger and previous BSL issuers have been taken out of the market?

Clearly, the growth in the private credit market has been dramatic over the past few years both in terms of AUM and capital raised. The private credit market traditionally provided financing to smaller issuers — however in recent years, the size of transactions has increased alongside the growth in AUM. 

The frequency and size of private credit deals are likely an evolution in the market resulting from slower BSL CLO new issue creation, run-off of traditional US CLO AUM due to the end of reinvestment constraints, and the overall increased demand for private credit loans from investors. 

This trend has carried over to CLOs, where private credit CLO new issue volume has made up roughly 20% of the total US CLO issuance this year, double the prior several years’ volume. Ultimately, liquidity is important for both issuers and investors, so while there is an opportunity for increased growth in private credit transactions today, it's reasonable to assume that when we see new issue BSL CLO creation begin to outpace the run-off of non-reinvestment CLOs, the market will see healthy demand drive BSL creation.

3. With loan recovery rates inverted and default rates forecasted to rise, how can CLO managers avoid credit losses impacting portfolios?

Managers need to remain focused on high quality credit selection with an eye towards solid documentation and active engagement. Barings’ fundamental bottoms-up approach coupled with an experienced capital solutions team provides the necessary tools to manage through an evolving credit cycle.

Initial strong underwriting decisions are the foundation for minimizing defaults but ultimately, and more than ever, lenders are coordinating and communicating their efforts to best position themselves for long-term value preservation.  

Each cycle is different, but ultimately strong credit selection, active engagement and trading are essential.

4. With 40% of the CLO market to soon be out of their reinvestment periods, what can managers do to keep those deals fully invested and in the money?

CLO managers need to focus on managing their weighted average life test. There will be a certain amount of opportunistic resets that could lower this number. However, assuming 40% of the market is out of reinvestment, managers will often have to compete for the same shorter WAL loans.  

The more proactive a manager can be, the better. That being said, it is important to understand the credit quality of short WAL paper as not all short WAL paper is of equal credit quality.

5. As a global CLO issuer that priced a CLO in all three markets this year, how does Barings manage the different dynamics in each market that are happening simultaneously?

The strength of Barings’ CLO platform is the depth and experience we have in US, European, and middle-market CLOs. Our teams leverage all of this experience and internal communications to analyze the constantly shifting market dynamics and help better inform our issuance strategy to achieve the best execution for our investors.  

Our roots are based in CLOs, having issued our first US CLO 25 years ago as a division of First Union and marketed under the name First Union Institutional Debt Management, or IDM.

Our large and experienced team has navigated multiple credit cycles, including the Global Financial Crisis and Coronavirus pandemic. Our consistency has grown the platform into a top 20 CLO issuer globally by AUM and, by our count, Barings CLO 2023-II, which closed in July, became the 100th CLO we have managed.

6. Will CLO manager M&A activity pick up with some managers struggling to raise equity capital to reset legacy CLOs in the current market?

There has been a fair amount of manager consolidation since 2020 and one could expect that trend to continue. With the challenge of procuring CLO equity and triple-A checks in the current market, some managers that are unable to issue a new deal may result to consolidation as a strategy.  

From a triple-A investor's perspective, this consolidation can be a net positive as being acquired by a larger firm increases the liquidity and viability of the platform post-acquisition.

7. Has the market seen a shift in CLO docs and stips as post-reinvestment trading becomes ever more important?

The “snooze & drag” stip has been an interesting topic this year. This has typically been more of a debate in European deals as some managers could have avoided voting on a maturity amendment — “snooze” — and be “dragged” along with the longer maturity without technically breaking their WAL test.

8. What effect will the growth of ETFs have on the CLO market?

CLO ETFs currently represent a relatively small investor base in the CLO market, with only around $5bn in holdings, which is less than 0.5% of the total $1.3trn CLO market. 

However, this retail exposure to the CLO market should help demystify some commonly held misbeliefs about the asset class and could lead to increased demand and liquidity in the future as investor adoption rises.

9. What advice would you give to young women starting out in finance?

I think it’s the same advice I’d give to anyone starting out in finance — work hard and try to learn as much as you can. It’s an interesting, ever-changing market so being able to adapt is also a key skill.

9Questions — Adrienne Butler, Barings — US triple-A demand may return soon

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