In April, I wrote about how institutional investors were selling floating-rate, AAA-rated collateralized loan obligations (CLOs) as a source of funds to rotate into other fixed income asset classes. This week’s chart highlights the flow of funds and performance for leveraged loans, which are the assets that are actively traded in a CLO vehicle and collateralize the debt classes (tranches) that are issued to investors.
The approximately $1.5 trillion U.S. leveraged loan market consists of typically 5- to 7-year, floating-rate loans made to companies with below investment-grade credit ratings. The performance of leveraged loans — and a CLO manager’s ability to trade the CLO’s loan portfolio — can drive the performance of CLO debt and impact the amount of interest coverage and credit support (par subordination) available for CLO debt.
For the first four months of 2022, inflows into U.S. leveraged loan funds were robust. Leveraged loans offered wide spreads on floating-rate debt at a time when the risk of rising interest rates was the primary concern for investors. As inflation data continues to print higher, there is a growing concern that the Federal Reserve’s commitment to bring down inflation will drive the economy into a recession.
The risk of recession has caused leveraged loan spreads to widen and prices to drop on growing credit-risk concerns. Spreads on CLO debt have also widened materially since April, which has made the economics of issuing a new CLO less attractive. CLOs and leveraged loan funds comprise over two-thirds of the demand for U.S. leveraged loans. The lack of new CLO creation, coupled with outflows from leveraged loan funds, has removed a strong technical support for leveraged loan prices that we experienced to start the year.
Current levels for leveraged loan prices and spreads on CLOs have attracted investors’ attention, even with the growing risk of a more severe or prolonged economic contraction. The secondary CLO market has felt spotty, with investors sitting on the sidelines as spreads widen and then scrambling to add investment-grade paper at the wider levels before spreads retrace tighter. For investors finding it challenging to add CLOs at target spread levels in secondary markets, the primary market can present a more scalable opportunity.
New-issue CLOs utilize a warehouse facility — short-term financing for a CLO to acquire leveraged loans before its debt is sold to investors. CLO warehouses are aging and CLO issuers are utilizing different structures in order to issue their debt in the primary market. CLOs issued with a 3NC1 (3-year reinvestment period, 1-year non-call period) or static (no reinvestment period, 1-year non-call) structure have become more common compared with the traditional 5NC2 structure.
Leveraged loan prices have declined and loan funds have experienced outflows this summer as the market prices in the risk of a recession. Pressure on CLO spreads and loan prices creates unfavorable economics for the CLO arbitrage, which reduces demand for leveraged loans from new CLO creation. Leveraged loans will need to find support from the CLO primary market, which, in turn, is subject to demand for CLO debt from investors. In the near term, I expect leveraged loan prices and CLO spreads to remain choppy from supply-and-demand technicals until there is more conviction on where the economy is headed.
The S&P/LSTA Leveraged Loan Index (the Index) is a market value-weighted index designed to measure the performance of the U.S. leveraged loan market based upon market weightings, spreads and interest payments.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
Opinions and statements of financial market trends that are based on current market conditions constitute judgment of the author and are subject to change without notice. The information and opinions contained in this material are derived from sources deemed to be reliable but should not be assumed to be accurate or complete. Statements that reflect projections or expectations of future financial or economic performance of the markets may be considered forward-looking statements. Actual results may differ significantly. Any forecasts contained in this material are based on various estimates and assumptions, and there can be no assurance that such estimates or assumptions will prove accurate.
Investing involves risk, including possible loss of principal. Past performance is no guarantee of future results. All information referenced in preparation of this material has been obtained from sources believed to be reliable, but accuracy and completeness are not guaranteed. There is no representation or warranty as to the accuracy of the information and Penn Mutual Asset Management shall have no liability for decisions based upon such information.
High-Yield bonds are subject to greater fluctuations in value and risk of loss of income and principal. Investing in higher yielding, lower rated corporate bonds have a greater risk of price fluctuations and loss of principal and income than U.S. Treasury bonds and bills. Government securities offer a higher degree of safety and are guaranteed as to the timely payment of principal and interest if held to maturity.
All trademarks are the property of their respective owners. This material may not be reproduced in whole or in part in any form, or referred to in any other publication, without express written permission.