US CLO spreads have been stubbornly wide since the start of the Russia-Ukraine war in February 2022 and high financing costs are not conducive towards creating attractive CLO equity profiles.

But at the start of this year the US CLO market underwent a sharp rally which saw CLO liabilities tighten at breakneck speed and loans rally to close to par. The swing in liability spreads has made the CLO arbitrage attractive again.

Last year, 90% of 2023 primary US CLO equity was bought by the CLO manager that priced the CLO (captive equity), according to a Citi research report. In 2022, that figure was 47%, the report states.

Instead, typical third party US CLO equity investors rotated into primary mezzanine tranches, or exclusively played in the CLO secondary market, sources said.

Through the first six months of 2023, US CLO double-B spreads averaged SOFR+867bps, according to 9fin data. With SOFR being above 5%, the all in payment was 12%-13%, sources said, which in some cases was higher than the modelled returns for the CLO equity tranche.

Captive equity conflict

The scarcity of third party capital for primary US CLO equity meant that some CLO managers needed to raise a captive equity fund. Although third-party equity investors are back, captive equity is still expected to drive primary issuance.

Captive equity funds driving CLO creation can create some conflict in the CLO market according to Dagmara Michalczuk, principal and portfolio manager at Tetragon. She states, "We need the CLO market to function for the loan market to function so captive equity capital is helpful to keep the market active. But there are also a number of potential conflicts of interest for captive funds where equity capital deployment is directly linked to CLO AUM growth. When CLO equity is closely connected to AUM expansion, it can reduce the arbitrage issuance discipline that should exist for equity capital and create inefficiencies in the market."

Although conditions have much improved, there were still opportunities to buy primary CLO equity at attractive levels in 2023, according to Ujjaval Desai, head of structured products investing at Sound Point Capital Management. He spoke to 9fin about investing in primary equity last year for our 9Questions feature.

He also spoke to us for this article and highlighted the differences between investing last year versus this year.

"2022 and 2023 were principal-only trades,” he said. “The cash-on-cash distributions were not great as the liabilities were expensive, but you were buying loans at a discount (95/96) which created significant upside that has been realized. This year we are back to an interest-only trade and back to looking at the spread arbitrage and letting the structure and leverage work for you. But there is limited upside on the loans as they are trading close to par."

Desai stated that 2024 is one of the best years to invest in third party US CLO equity in a while. "The arbitrage this year is 20bps-30bps higher than it was before the rate volatility in 2022 began. In 2021, when loans were close to par, the modelled equity returns were low-to-mid teens and now this year it is more like mid-to-high teens, so it’s very attractive."

There is not just one way to model a good return for CLO equity this year. Dan Wohlberg, principal at Eagle Point Credit Management, states that the warehouses that were ramped in 2023 are in-the-money and this is creating third party equity opportunities.

"You can combine last year’s loan prices with today’s tighter liability stack," he said. “We have done nearly the same number of new CLOs this year as we did throughout the whole of last year,” he said, underlining how busy (and compelling) the primary US CLO market has been this year.

While Sound Point has focused on other types of primary equity trades. Desai said that a lot of deals this year have been ‘print and sprints’.

Not all equity investors have returned yet. Michalczuk told 9fin: "We expect to be more active in primary CLO equity in 2024 versus 2023, which was a year during which we did not find new issue equity arbitrage as attractive as other opportunities in the capital structure, particularly CLO mezzanine.”

Technicals keep CLO triple-As in check

But while there are different strategies for CLO creation, be it older warehouses or print and sprints, the tiering (and therefore differentiating) between CLO managers is compressing.

Wohlberg stated that a lot of the warehouses that were opened in the last year were with tier one managers, as the basis between tier one and the rest of the market was too large to make the economics work. But that may change. “Today, that is no longer the case as the basis between the tiers has decreased from nearly 50bps-60bps down to 10bps-15bps, or less."

Tier one managers last year were able to print their triple-A tranches at around S+170bps-180bps, while tier two and newer managers were in the low-200bps. This year tier one managers are printing at S+150bps and lower tiers are around S+160bps, according to 9fin sources.

While things are better for third party CLO equity, things are changing with the spot basis for CLO arbitrage (ie where the arbitrage of loans and CLO liabilities is today) tightening, sources said.

US CLO triple-As are sticky right now and are not showing signs of tightening from tights of S+148bps any time soon. On top of this, CLO-quality loans are trading at or close to par which removes any potential upside in price.

"Triple-As still need to tighten with where today's loan prices are. Before the last few years of COVID and rate volatility, triple-A spreads were in the lower 100s versus similar loan prices." Wohlberg said.

Sources also said that a narrow triple-A investor base is delaying potential tightening as the sheer supply of CLOs cannot be absorbed.

On top of this, there has also been recent widening in US CLO junior mezzanine tranches. This could affect the CLO arbitrage if spreads leak out further.

According to Desai: “The recent widening in the mezzanine tranches has widened overall CLO funding costs by 5bps-10bps. With 10x leverage, that is reducing IRR by 50bps-100bps, but the returns are still in the mid-to-high teens so that can be absorbed".

Out with the old CLOs

Another factor in why third party US CLO equity is more prevalent this year is the increasing number of CLOs that are being redeemed thanks to loan prices rising. Last year, post-reinvestment US CLO equity was mostly underwater due to loans trading well below par. Now equity net asset value (NAV) is positive again and so equity investors are redeeming older CLOs to realize gains.

Redeeming legacy CLOs also has the added benefit of freeing up investor capital.

Another benefit of an increased number of CLO redemptions is that it offers an opportunity for other CLO managers to pick up loans if the collateral is listed on the secondary market in the form of a loan BWIC. Loan issuance is scarce, according to sources, with the majority of issuance this year being repricings or refinancings so when loans are listed on the secondary market, they are trading at high levels.

According to sources, loans in BWICs are trading closer to the ‘ask’ than the ‘bid’ when it has typically been the other way round in years past.

Bank of America and JP Morgan researchers have already raised their US CLO issuance forecast for 2024, however BofA points to a lack of loan creation as an obstacle. The report states that, “collateral sourcing remains the key challenge for CLO creation. New leveraged lending activity such as from M&A or leveraged buyouts needs to pickup.”

Even though conditions are better for CLO creation and for third party investing, there is still uncertainty in the market for the rest of the year. Specifically regarding interest rates cuts and whether the economy will have a soft landing to the inevitable cutting of rates, sources said.

The uncertainty though is not being felt in primary issuance just yet. There has been $29.7bn of US CLO new issuance this year already. In 2023, US CLO new issuance did not cross $29.7bn until August. On top of this, only $2.2bn of the issuance has been short-dated, according to 9fin data, as investors and managers are locking in two years of call-lock and five years of reinvestment.

But Michalczuk said there is still value in having short-dated CLOs, stating "one of our focuses is to have a mix of durations due to the volatility the market has been through.”

Of course, one place to find a mix of durations is the CLO secondary market.

But sources said that the relative value of the secondary market compared to the primary market has compressed significantly this year thanks to a furious rally there too. They said that last year, the convexity on offer in the secondary market and the lower prices were very attractive but this year the value has switched to primary.

It looks like third party primary CLO equity investment is going to bounce back — but captive CLO equity funds still lurk in the background.

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