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Charlie Dinning

The recurring question in the US CLO market, and indeed in Europe, is “does the arb work?” and for most of the year the answer, for third party equity investors at least, has been “no”.

Most CLOs printed this year have been achieved using captive equity funds, sources say. This has been driven by expensive liabilities, specifically triple-As and double-Bs. Triple-As have been wide compared to previous years, with 195bps about the average coupon for a five-year reinvestment, two-year non-call CLO in Q1 and Q2 2023, according to 9fin data.

This year managers have priced double-Bs wide of 800bps, and in some cases above 900bps, which brought the total return of the tranche to around 12-14%, once one has accounted for Sofr. This matches the modelled equity return in a new issue CLO from previous years, investors tell 9fin, so CLO equity investors preferred instead to invest in the double-B tranche for its par subordination and lower risk profile.

This presented an obvious hurdle to CLO creation. But there was one silver lining, in that loans traded at a discount, which made it easier for managers to ramp up CLO warehouses. An ensuing pull-to-par effect should increase excess spread within a portfolio and leave the CLO in good health for a reset or refinancing down the line, sources say.

However, in the last quarter CLO liabilities tightened as the market rallied and CLO triple-As for 5/2 deals gapped in to around 185bps on average, according to sources. BlackRock set the benchmark in August as it printed Magnetite XXXVII’s triple-As at 165bps, and subsequently also achieved the joint-tightest triple-A print for a three-year reinvestment, one-year non-call CLO as it priced Magnetite XXXIX at 155bps.

Double-Bs have also tightened a lot, as Oak Hill Advisors printed this tranche of OHA Credit Funding 16 at 675bps — the first within 700bps since 2015, according to one source.

But within this tightening trend, there was an apparent dispersion between managers and tiers. That could also be a theme for Q4, some market participants believe.

“We’ve seen high levels of dispersion in primary triple-As this year,” said Stephanie Walsh, head of US CLOs at Bain Capital, in Boston. “In previous years it would be 20-40bps but this year within a quarter it increased to 90-95bps. We expect the trend to continue for the rest of the year, which calls into question if managers continue to pursue the deal or elect to pull them.”

Despite a challenged CLO arb throughout the year, issuance has been steady with over $65bn of new deals, according to sources, but this has not been matched by loan issuance.

“Something that we are continuing to monitor is that net issuance in CLOs this year is $50bn, but bank leveraged loan net issuance is negative $15bn which is a huge mismatch,” said Edwin Wilches, co-head of securitized products at PGIM in New Jersey. “It’s one reason why loans continue to be so well-bid and is making the ‘arb’ tough.”

With so little loan issuance, those that CLO managers want in their portfolios have been very well bid, managers tell 9fin. Appetite picked up in September as managers brought 23 new CLOs, according to 9fin data, despite the primary market not opening until 11 September after Labor Day. The pipeline for Q4 is filling up and is expected to exceed Q3’s issuance which was over $20bn, say sources.

Along with the bulging new issue CLO pipeline, a rising tide of expensive 2022 vintage CLOs exiting their non-call periods have become ripe for a reset or refinancing. With all this competition in the market, another mismatch is that assets have continued to tighten but CLO liabilities may not keep pace, sources say.

CLO demand has added technical bifurcation to the loan market, as those loans CLO managers look to buy for their portfolios are typically priced between 98 and par, but much of the available universe is trading below 90. 

New issue CLOs coming to market often have a weighted average purchase price of around 98/99, sources say, which shows the kind of loans managers favor. That is a change from earlier in the year when, as mentioned above, loans were at a greater discount and CLO managers could buy a portfolio at a lower price.

This has caused managers to change tactics.

“The approach to how you ramp has changed,” said Walsh. “At the beginning of the year, we were targeting secondary assets due to the discount that was available. But with the number of loans trading above par, managers need to have a warehouse open longer and accumulate some new issue paper.”

But waiting for a regular-way 5/2 CLO to have better economics isn’t everyone’s preference. Instead, investors and managers introduce new structures to make deals more attractive.

Two new CLO types have hit the market as a result — ‘lightly syndicated CLOs’ and ‘alto’ CLOs.

Neuberger Berman pioneered the lightly syndicated CLO structure with Neuberger Berman LaSalle Street Lending CLO I. The CLO’s portfolio was structured so that 60% will be add-ons with the other 40% regular broadly syndicated loans, according to sources.

Neuberger Berman also split the portfolio by how widely distributed the loans are. The firm is part of a small syndicate of lenders taking the add-ons, sources say. 10% of the portfolio is syndicated to 5-10 lenders, 20% syndicated to 10-25 lenders and 30-40% taken by 25-40 lenders. The rest is broadly syndicated.

Panagram and Octagon Credit Investors created the Alto structure. This mirrors a secondary trade in that the new issue CLO portfolio looks like the broader array of loan prices investors can buy into on the secondary market. The CLO was named Octagon 70 Alto.

The CLO priced with a weighted average purchase price of around 95/96, which was around 2-3 points cheaper than new issues coming to market. To reflect the stressed nature of the portfolio, Octagon and BofA sold all of the debt bar the two triple-A tranches at a discount, sources told 9fin.

“We created the alto style deal to aim for increased modelled equity returns in the primary market,” John Kim, chief executive officer and chief investment officer at Panagram told 9fin. “The structure created a mid-teens return compared to high-single digits for regular new issues. We then sold a minority stake in the equity of the CLO which was oversubscribed.”

Octagon 70 Alto was well-received by investors — so much so that another equity investor and Carlyle Grouprecreated the trade on Carlyle 2023-4. Carlyle 2023-4’s WAPP at pricing was 96.7, according to sources, but the prices and discount margins of the CLO were not disclosed.

Not everyone is a fan of new CLO structures. 

“We’re seeing managers stretching to make a structure that works, and pushing out concentration limits, such as percentage of the portfolio that can be second lien loans or higher exposure to certain industries,” said Laila Kollmorgen, portfolio manager at PineBridge Investments in Houston. “This isn’t necessarily positive as these deals can take away the discipline of putting together a conservative portfolio. We saw this in 2019 and that vintage has not performed as well.”

One positive for regular-way new issue CLOs is that loan supply began to pick up by the end of September and issuance has come to the market with attractive spreads. This could help bring back third party equity; if CLO liabilities remain where they are or go tighter for the upper-tier managers, while loan spreads widen, the arb will improve.

Vince Pompliano, managing director at Benefit Street Partners, said: “I am optimistic third-party equity investors will return to the primary CLO market given the cash flow arb has improved due to tighter liabilities and new issue loans are coming with wider spreads and more OID than is available in the secondary.”

Walsh concurs that loans are paying well from both new issue and repricings. 

“New issue loans are coming to the market with good spreads, even with the higher demand, and we’re also seeing repricings not cut the spread as much as before,” she said. “In 2018, for example, a repricing would lower the spread by 100bps, but this is now closer to 25-50bps.”

But she also warns that investors need to be acutely aware of refinancings. 

“What investors need to be aware of though is that some borrowers are trying to remove the CSA when repricing, so what looks like a cut of 25bps to the spread, could be as much as 50bps depending on the tenor to which the loan is tied.”

One of the many reasons why triple-A spreads have been so wide this year is the inactivity of US banks and other anchor triple-A investors the market has relied on in the past, sources tell 9fin.

Banks have focused on their balance sheets, which are full, and there has also been a duration mismatch, sources say, especially after the banking crisis earlier this year. There has been a steady decline in securities and a rise in loans on the banks’ balance sheets, one investor said.

The new Basel III endgame proposals could be a big change in the market, sources say. 

"Many traditional triple-A investors have not been very active this year but these investors may return and redeploy at wider spreads as the pace of amortizations and liquidations increases,” said Pompliano. “The recent Basel III proposal may also improve US bank demand for CLO triple-A beginning in 2025 as risk weighted assets is reduced from 20% to 15%.”

The new regulations also propose CLO double-As for banks to carry a new RWA of around 80%, up from 20%.

Banks will likely therefore only buy triple A-rated paper, but they could ask for higher par subordination to make sure their investment does not lose its triple-A rating. That way, if a portfolio does begin to default, there is better protection.

There is hope that this frees up capital for US banks as they now require less leverage against triple-A rated CLO paper. Therefore there are grounds for US banks to return to CLO investing. But there have been new global and domestic entrants to the triple-A tranche to pick up the slack, say two CLO managers.

Banks also continue to hold a lot of CLO paper, sources say, but one question is whether they roll into a reset/refi or rotate out of the deal to free up capital.

For CLO managers not on a pre-approved list, triple-As are tough as there are not enough buyers to go around and syndicating the tranche makes it difficult to keep levels tight, said one CLO investor.

But the CLO market is pulling levers to assist with new issue triple-As. One tactic is that arrangers of new issues are buying a portion of the triple-As in tickets somewhere between $30-100m, according to a CLO manager. One bank is going a step further by backstopping the triple-A tranche at launch, but then tries to sell its position down as the CLO moves towards pricing.

The growth of CLO ETFs has helped the triple-As find a home in primary and secondary markets, sources say. CLO ETFs have had high demand and inflows this year and most of those available to retail investors invest in triple-As. Janus Henderson’s AAA CLO ETF has crossed $4bn in assets under management, for example. 

As 9fin has covered, there has been a severe lack of resets, refis and liquidations in the CLO market, leading to a reinvestment crunch. Around 70% of the market is callable, according to a 21 September JP Morgan research report, but not much of that is in-the-money for a reprice.

However, with loan prices rising in recent months, CLO net asset values recovered from below zero and this makes liquidating post-reinvestment CLOs an option, which some managers are using. This is true even for a deal that has not left its reinvestment period.

“An increase in liquidations is good for the market,” said Kollmorgen. “There are 2012/13 vintage CLOs that are getting liquidated that should not have gone on as long as they have. Call the deals, and roll the equity into better CLOs.”

CLO liquidations are also viewed by many as good for the market since they free up capital for investors that were in the deal.

But not all CLOs are in a place to be redeemed. 

“We believe liquidations are still tough as loan prices are lower than where they were when the deals priced or were reworked in 2018/19,” said Panagram's Kim. “We’d love the extra tenor and to recycle cash but we prefer to let those post-reinvestment CLOs run longer and amortize a bit more as the cash-on-cash returns are so high.”

If liquidating is not the best route for a CLO, what are the other options?

Some managers are doing a ‘quasi-reissue’, which sources say has been around for years. A manager can take an existing CLO it has under management, keep some of the portfolio while selling off a small percentage of the loans, then roll the existing collateral along with some new assets into a new vehicle. This ‘new’ CLO is most likely to be short-dated as the loans are older and have fewer remaining years to maturity, sources say.

This is beneficial for the new and old deal, according to one equity investor. Having no bid-ask issue when these trades occur means they can trade at the mid-point, which solves settlement time issues. It is also beneficial for other CLO managers as they are able to source short-dated loans for their portfolios via a loan bwic. Short-dated paper is incredibly useful for CLOs pushing up against weighted average life tests.

CLO market participants expect more resets and refinancings to hit the market in Q4, as mentioned. But whether existing investors roll over into the new vehicle or rotate out is a topic of conversation.

CLO investors tell 9fin they decide deal-by-deal whether to rotate or roll over as there is a lot of supply in which to deploy. Investors have been rotating out of CLOs as they have been offered bonds in deals they were not originally in, said one senior investor.

“2023 has been the year of private credit,” said one CLO investor, and it’s hard to disagree with the designation. The private credit market has grown to around $1.5tr, according to Dechert, around the same size as the leveraged loan market and also the high-yield bond market. Private credit also has its claws on the CLO market.

Middle-market or private credit CLOs have historically had a 10% market share of the US CLO market. But this year the figure has risen to 20%.

This includes a record-breaking August for mid-market CLOs, in which $2.83bn priced. In comparison, August 2022 issuance was $1.17bn and August 2021 was $2.04bn. But there are questions about whether this pace of issuance can continue.

“Mid-market/private credit growth is limited by how long it takes to originate the loans,” said Kim. “It’s much more difficult to originate compared to BSL as it really requires boots on the ground, so I think mid-market issuers will continue to be selective about accessing the CLO market and won’t necessarily be 20% of the CLO market going forward.” 

As a percentage of the market, mid-market CLOs might be 20% but that is because US broadly syndicated loan issuance is also down, Kim added.

But even if the growth of private credit doesn’t take a greater market share of CLO issuance, it may take some borrowers away from the broadly syndicated market and reduce the number of assets available for CLO managers.

“We have seen a number of takeouts from the BSL market to the private credit market,” said Walsh. “Several triple-C rated assets in our portfolio have been refinanced by private credit lenders and fully left the BSL market.”

Relative value is often referenced and the CLO market is incredibly attractive compared to other similarly rated asset classes, sources tell 9fin. But some multi-asset shops have been rotating out of CLOs in secondary, as CLO paper is trading close to par while other assets linger in the 80s and 90s, traders say.

The CLO secondary market has been very busy this year, according to sources, but supply has been well-bid. This has made the US secondary market very rich compared to the primary market, according to two investors. In Europe the dynamic is the other way round, with primary rich compared to secondary, one global investor said.

In the US, even tier-two CLO paper is fully bid and investors are missing out more often than they are buying, traders say.

For global investors, the relative value between the US and the European CLO primary market has recently undergone a shift.

“For most of the year, Europe had an edge over the US in terms of where things were pricing, especially AAs down to BBBs,” PGIM's Wilches stated. But he added: “This has shifted recently and now European AAs are on top of US AAs which from an unsophisticated analysis doesn’t make sense as the US has better liquidity and a better macro environment.”

CLO manager consolidation is widely anticipated in Q4. According to one CLO investor there are “over two dozen firms up for sale right now”.

"It would not be surprising to see the pace of M&A pick up”, said Pompliano. 

Numerous firms have only a handful of CLOs under management but are unable to fundraise for captive equity. This means they are unable to grow the business since third party equity is rare and unlikely for a small CLO manager, while their existing CLOs inch towards the end of their reinvestment, three sources said.

Meanwhile, several firms are looking to enter the CLO market, according to one CLO equity investor, as CLOs offer sticky AUM and fees.

The market has had eight debutants in the US this year, while Apollo's Redding Ridge Asset Management absorbing Gulf Stream Asset Management is another example of CLO M&A.

Q4 US CLO outlook — New structures and the roll/rotate/liquidate dilemma

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