CLOs and Leveraged Loans — Chicken or the Egg?

July 28, 2022

Sources: Bloomberg, J.P. Morgan Sources: Bloomberg, J.P. Morgan

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.

Key Takeaway

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.

Index Definition:

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.

Tags: CLOs | Leveraged Loans | Fixed income | Credit risk | recession

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