The U.S. CLO market closes a difficult year in not dissimilar shape to where it started, which is impressive given the turmoil that the world has faced. The tumult in 2020, of course, led to heightened volatility, a swath of loan downgrades, a pick-up in defaults, and at one point a sharp rise in the costs of raising a CLO, namely liabilities. Against this backdrop though, the CLO new-issue market has regained its poise, having found ways to overcome the crisis, all of which will have a marked impact on how 2021 shakes out.
To be sure, 2020 will not go down in the annals as a strong one for supply, with $89.4 billion issued across 209 deals through Dec. 16. That makes it the second-worst year on these measures since the start of 2016, though it is broadly in line with the average for 2016-2019.
Meanwhile only 92 managers issued CLO vehicles in 2020 through Dec. 16, which included five first-time managers, the lowest such number since 2016, and is well off 2019's record 108. In addition, 30 managers that issued in 2019 have not returned in 2020, or 28%. That is a sizable proportion, and one of the key things to watch for in 2021 are possible consequences of this — be it manager consolidation, or a surge in issuance due to pent-up demand.
Perhaps the biggest boon for the market will be liability costs, which have been volatile in 2020, like so many asset classes. Average triple-A spreads blew out 69 bps in the second quarter and then tightened back in by 55 bps by the end of the fourth quarter through Dec. 14. Similarly, the weighted average cost of capital shot up 59 bps and then retraced 46 bps. Moreover, as 2020 comes to an end, triple-A tights for three-year reinvestment period deals is L+120 bps, and for five-year deals with just one triple-A tranche it is 132 bps, which is in-line with where new issues for Tier 1 managers were printing at the end of 2019.
Against this backdrop, market participants say the following drivers will be important for 2021.
Drivers to the upside:
Vaccine & technicals. The gargantuan support of the Fed and Treasury helped stabilize markets during the year, and likely staved off a savage economic slump. Then came news of what appear to be three effective vaccines, and the market went from stable, to slowly recovering, to turbo-charged/risk-on. In a low-yield environment, CLOs are particularly attractive on a relative-value basis, while loan asset prices are supported. Moreover, it is clear that the economy will not be allowed to fail, and that significant support measures are in place to try and soften the blow of the lockdown and social distancing measures. These are also helping keep the default rate low, while a vaccine is the path to normalization for companies across the globe.
Tightening liabilities. The cost of raising a CLO has come down, and stabilized, and there are high hopes for further tightening in 2021. CLO bankers comment that in the fourth quarter one of the big three U.S. bank triple-A buyers returned, namely Wells Fargo, and sources expect the other two — Citi and J.P. Morgan — to resume buying soon. Analysts at Citi, meanwhile, comment that banks reduced their market share by 10% this year but that insurance filled the void, increasing their share from 19% to 32%, indicating a deeper liability pool should everyone come back.
Moreover, interest is emerging out of Japan again, CLO bankers say, though to-date this does not include Norinchukin. The former whale of the triple-A market is said to have made no decision about returning, but some liability investors note that 2021 will see capital returned to Norinchukin through refis/resets, and this may burn a hole in its pocket. Meanwhile, thanks to favorable yen-hedged spreads, triple-As are attractive to Japanese buyers, on a historical comparison.
Many bank analysts are forecasting further tightening too, with Barclays looking for triple-As to tighten 10-25 bps by the end of 2021, while BofA and J.P. Morgan are forecasting 10 bps of tightening.
Rise in resets/refis. With CLO liabilities falling since the middle of the year, the swath of new issues printing this year with a non-call one clause will be ripe for a rest. Coming into 2020, the feeling was there would be a rush of resets too, which never came to fruition, meaning there will likely be pent-up supply from even before this year. This in-turn should lead to improved equity returns for the vintages that can lower their liability costs.
Analyst forecasts for refi and resets are quite varied, with J.P. Morgan at $35 billion, while Citi is sees some $75 billion, and Barclays and BofA in between. Anywhere in this range would be a marked increase on this year but still considerably shy of 2017 and 2018 totals of $167 billion and $156 billion respectively, according to LCD.
Primary loan pick-up? The primary loan market posted a respectable institutional volume of $287 billion this year (through Dec. 16), though it is down from $310 billion in 2019, and is the lowest annual volume since 2015. Given the backdrop this is not surprising, but with a vaccine now in play, private equity still sat on huge amounts of dry powder, and is said to be back buying, even at high multiples. With debt markets clamoring for assets, the scene is set for a pick-up in loan issuance next year.
Indeed, BofA, for example, is forecasting $300 billion of new money issuance next year, compared to 2020, during which LCD recorded $208 billion of institutional issuance that wasn’t for refinancing (through Dec. 16).
CLO equity buyers returning. According to CLO syndicate officials, at the start of the crisis it was all but impossible to sell CLO equity as the arbitrage — the amount of excess spread generated from the collateral pool over the cost of the vehicle/liabilities — was negligible. It has since improved, hence the increase in CLO issuance, leading to more equity buyers returning, and importantly, a tentative return of third-party equity buyers. This could help support smaller managers, or those without deep pockets and access to risk retention money, come to market.
Further market normalization. Since the crisis hit, 62% of new issues have been three/one deals (three-year reinvestment periods/one-year non-call). However, since mid-September, 15 five/two deals have emerged, which was the market standard structure. This again points to increased appetite from CLO equity investors, as they previously wanted non-call one deals with the hope of resetting liabilities next year and improving the arbitrage.
Improving test scores. The pandemic was suggested to be the type of event that could lead the CLO structure to fail en masse, causing further economic carnage and substantial losses. Indeed, for the last few years CLOs have often been in the crosshairs of market commentators, with some forecasting they would be the next cause of financial Armageddon. Such forecasts have not come to fruition, as the CLO structure held up, as it was designed to do. Indeed, the GAO announced this week that leveraged lending, and specifically CLOs, pose no current systemic threat to financial stability. Those who are bearish about the asset class will point to unprecedented fiscal and monetary support as staving off a day of reckoning, but this intervention arguably saved many financial asset classes from dissolving.
As 2020 draws to a close, the number of CLOs failing their economic tests — some of which lead to coupons on CLO notes being switched off — has dwindled markedly. Analysts at Citi, for example, note that, at the start of December, "7.7% of reported deals are currently failing junior OC test, declining from 9.7% in October," with analysts at J.P. Morgan noting that they were as high as 20% in June. Meanwhile analysts at Barclays said, "CLOs were not immune to volatility in 2020 but still performed as advertised, providing more evidence to investors, managers, journalists and regulators that today's CLOs are a far-cry from the CDOs of 2008."
Regulation. This was a good year for the market from a regulatory perspective, with the Volcker Rule being loosened to allow CLOs to buy bonds, and with banks subsequently not being penalized should they buy such CLOs. This opens the collateral pool up for CLOs, and with asset-sourcing still a likely hurdle for new CLO creation, this can only be a good thing. That all said, expect the phasing out of Libor to be in focus next year, which may be more a hindrance than a help.
Drivers to the downside
The economic backdrop. While fundamentals will likely continue to be ignored in favor of red-hot technicals, no one doubts that the underlying economy, as well as corporate balance sheets, are in numerous instances flashing red. Some liability investors say that the economic backdrop is the worst it has been since the Great Depression. Leverage is rising as companies take on more debt to get through the crisis. More corporate debt allied to rising unemployment in the future is a potentially dangerous cocktail.
Volatility. With investors rushing to add risk in the wake of vaccine news and already on a bull run, thanks to fiscal and monetary support, there is arguably greater risk to the downside. Any hiccups, big or small, as regards the vaccine and the mammoth task of vaccinating the globe will lead to periods of volatility, CLO participants say.
Rising default rate. The US loan default rate closed November at 3.89% by amount, having hit a 6.5-year high of 4.17% in September. That should place this in the tailwinds section, but most expect it to rise further next year. Just 14% of recipients to LCD's Default Survey comment that 4.17% will be the peak. Access to functioning capital markets, cheap and widely available debt, should keep it contained in 2021.
Resets/Refis. As noted above, there is expected to be a significant increase in resets and refis, and while good news for those deals being reset or refinanced, it is potentially detrimental for the CLO new issue market. This is because those deals will take a significant amount of liability liquidity that otherwise might have supported new issues, and this will likely ensure a floor in liability tightening is reached faster.
Meanwhile, a disparity in liability levels between new issues and resets/refis is expected to open up in 2021. Indeed, some vintages will likely be defined as having either more or fewer COVID-19-affected names and sectors. This will mean some collateral pools have longer tail risk and more loans below par, whereas others might be cleaner, especially newer CLOs. It will all come down to manager style and the liability investors' risk appetite, but expect there to be greater dispersion between managers and vintages.
Asset sourcing. Not everyone is confident there will be a sizable increase in primary loan supply next year. J.P. Morgan, for example, forecasts $150 billion of net loan issuance next year, which in November they said was down 10% year-on-year. Meanwhile, secondary loan levels are, in many instances, back up at pre-COVID-19 prices, with the S&P/LSTA Leveraged Loan Index bid at 96.04 on Dec. 17, precisely where it was in late February. Thus, sourcing a sufficient amount of desirable and attractively priced assets will be a challenge.
Manager consolidation. While this can be viewed as a positive or a negative (stronger bigger managers versus fewer managers), either way it may become more pronounced in 2021. As noted above, 30 managers did not issue this year that did last. Consolidation was already witnessed somewhat this year, with BofA commenting, "Some of the prominent ones include the acquisition of Crestline Denali by Ares, Garrison point (3 BSL contracts) by Anchorage, Assurant by Morgan Stanley Investment Management and Garrison point (2 MM contracts) by Mount Logan (BC Partners)."
Most in the market expect to 2021 to host a higher volume in 2021. Barclays forecasts $90-$100 billion of CLO issuance, BofA $110 billion, Citi $100 billion, and J.P. Morgan $90 billion.