The U.S. CLO market is off to its strongest start to a year since the Great Financial Crisis, underpinned by a combination of falling liability costs, resurgent leveraged loan issuance, attractive relative value of the vehicles, and pent-up supply from managers after a tricky 2020.
"While everyone thought this would likely be a good year for supply, I am not sure many thought it would be quite this strong," says a CLO investor. "We are already pushing the boundary of how tight liabilities can go, after they ripped tighter. That has by and large been them following other asset classes, but CLOs remain attractive from a relative basis standpoint."
"Coming into the year our pipeline was solid, and it has taken off from there," notes a CLO banker. "Liabilities have probably come down more than we were expecting in the near term, and this has fueled both new issues and refis and resets."
Through March 22, the 2021 new-issue CLO market had already hosted 70 deals, totaling $34.3 billion, according to LCD. That puts it within reach of the record highs for both measures, which are the 77 new issues pricing in the fourth quarter of 2020, and $38.3 billion of paper issued in the second quarter of 2014.
Regardless of whether all-time quarterly records are set, this will still be the busiest opening quarter of a calendar year, with the average first-quarter tally for 2013-20 (inclusive) being 45 and $23.1 billion. Moreover, it is more than double the issuance from the first quarter last year.
The number of managers that have already issued in 2021 is indicative of the pent-up supply contributing to the surge in activity this year. Some 54 managers have printed a deal, already half of what was issued in all of 2019; that year featured the highest-ever manager count for a single year. While the current pace of issuance is unlikely to be sustained all year, a record manager count is a good bet.
It is not just the manager count either, with the more-prolific managers wasting little time in pricing multiple transactions already this year. Indeed, 12 managers have already priced two new issues, while two managers have priced three.
Arguably the most important catalyst for this elevated level of issuance has been falling liability costs. The cost of a CLO, measured through the weighted average cost of capital, has fallen 29 basis points so far in 2021, to 164 basis points over Libor, versus the previous quarter. Given that the fourth quarter of 2020 hosted a record number of deals, this has offered yet further fuel to an already raging fire.
Note though, the majority of supply in the fourth quarter — 62% — came with three-year reinvestment periods, with shorter-dated deals benefitting from a lower WACC. Just 28% of deals were issued with what had before COVID-19 been the market standard five-year reinvestment period.
This year, however, the liability backdrop has been sufficiently accommodating to allow for a clear resurgence of five-year reinvestment period deals, with 73% of new issues doing so. This clear shift, along with a tightening in the WACC, starkly highlights how liabilities have ripped tighter.
Moreover, liability costs through the CLO capital stack are now, on a three-month average, the tightest they have been since the second quarter of 2018. Given that it has not been cheaper to raise a CLO since the second quarter of 2018, as measured by the WACC, it is unsurprising that issuance volume is so high.
More recently, in percentage terms, the single-As have tightened the most quarter over quarter, by 18%, with the double-Bs tightening the least, at 12%. In truth, though, the degree of tightening has been consistently strong through the stack.
Fortunately for CLO managers, while spreads on leveraged loans have also declined sharply, the arbitrage remains palatable. Indeed, the rule of thumb for this investor class remains that a CLO needs 200 bps of excess spread, versus its WACC from the collateral pool. With the average spread on new loan issues from B/B+ rated borrowers coming in at L+370 bps in the first quarter, according to LCD, that rule of thumb has been achieved, on a rudimentary calculation.
Moreover, the average loan spread has been gently increasing through the quarter while liabilities have been tightening. This serves to make ramping a CLO easier.
Spreads being just about sufficiently attractive is only useful if there are enough loans to buy, of course, and coming into the year, subdued loan issuance was a concern cited by many in the market as a potential drag for CLO creation. This concern, though, has yet to be realized, as the first quarter has already featured $160.2 billion of supply, the most since the first quarter of 2017. That is roughly twice the loan volume recorded in the fourth quarter of 2020, and more than was issued in the entire second half of the turbulent 2020.
There is a caveat, however. The proportion of today's leveraged loan issuance that is refinancing existing debt, 47%, is the highest since late 2019, and is well ahead of the 30% quarterly average for 2017-20 inclusive. This means less "new money" loan paper has been on offer than meets the eye.
Another consequence of the falling yield environment — be it loan spreads or CLO liabilities — has been a surge in loan repricings. Already a staggering $144 billion of loans have been repriced this quarter (through March 18), the largest quarterly repricing volume since the first quarter of 2018. The average cut to the margin during the first quarter has been 67 bps (or 82 bps if the cut in the Libor floor is included).
While this has clearly not hindered new CLO creation, it can cause unwanted havoc for the arbitrage of older vehicles, many of which have far higher WACCs than vehicles being issued throughout the first quarter.
Pressure on the arbitrage, and even more so the falling cost of liabilities, has been behind an onslaught of CLO resets and refinancings. In short, it has been a record quarter for refis and resets, as more vintages are in the money for such action.
Another reason for the wave of CLO repricings is a hot secondary loan market. Through March 23, the S&P/LSTA Leveraged Loan Index had rallied 176 bps since the start of the year. This has aided CLO managers looking to soothe overcollateralization test failures in outstanding vintages, but puts more importance on the primary loan market, in order to ramp a new issue.
Looking ahead, there are signs that the tightening in CLO liabilities has reached a floor, at least for now. Indeed, there has even been a little widening. Market participants attribute this to a combination of new-issue fatigue and liabilities following other risk assets wider in the wake of recent spikes in the Treasury yield. Most expect the CLO market, though, to be relatively insulated from wider market moves, given that it offers a yield hike unrivaled by most fixed-income products. So, while a slowdown in new supply may emerge, the CLO market is expected to remain healthy.