The mood was cautious at DealCatalyst and LSTA’s annual CLO industry conference in New York this week as CLO managers and investors contend with AI-induced volatility and dispersion, geopolitical risk, and questions over the performance of CLO equity and captive equity funds.
Despite the clear headwinds in the market, CLOs have remained resilient. US CLO triple-As were one of the best performing asset classes in credit in March and liability spreads have tightened back to January’s levels, sources say. But further down the capital structure, dispersion in performance is becoming more and more pronounced and is only expected to widen going forward, leading to a re-tiering of CLO managers and some double-B tranches not returning par to their investors, panelists said at the conference.
Software/AI concerns
The topic du jour was unquestionably the AI-induced volatility that the market has been contending with for the last three months, with every panel referencing the disruption in some form. In a way, there were some similarities to this conference exactly a year ago when the ‘Liberation Day’ tariffs shook the market and jolted CLO liability spreads wider.
However, one panelist pointed out that at least with tariffs we knew roughly where and when they would hit compared to AI concerns which are affecting almost all sectors, but with no clear sense of when they will impact different issuers. For some it could be three months, for others it could be three years.
There was a brief indiscriminate sell-off across the whole market in February, but CLO managers have now had three months of data and analysis to make informed decisions on credits they want to own, and those they don’t, sources say.
Software exposure in existing US CLO portfolios has not decreased much, according to several panelists and also bank research desks. Both JP Morgan research and Bank of America research saw very little change in the share of software loans in CLOs, with BofA research stating that software exposure in CLOs has decreased from 15.1% to 14.7% year-to-date. However one panelist on the CLO investors’ panel stated that we are seeing materially lower exposure to software within new issue model portfolios, with some managers going from double-digits in their existing portfolios to single-digits in their modeled new issues.
This raises the question of what CLO managers are buying for their new issues instead, and which sectors they are opting to be overweight in, if not software. The CLO investor warned that this is where CLO managers have to be careful as they could end up being on the wrong end of two trades.
“If you think back to 2016/2017, oil and gas was a very topical, large sector, until oil prices crashed and caused losses,” the investor said. “So, the next wave of new issues had increased exposure to retail instead, and that didn’t work out very well.”
Outside of software/AI volatility, the Iran war has not had a direct effect on CLO-quality loans but is causing CLO managers to reconsider their exposure to consumer-facing businesses, several panelists said. Consumers are feeling the crunch from rising gas prices and the full affect of tariffs has not yet been felt; several panelists on the CLO manager roundtable panel mentioned that they have been rotating out of those loans.
Managers also mentioned that the repricing waves in the loan market over the last 18-24 months has meant that B3/B- rated loans are not attractive to own as the spread is not high enough for the risk, especially with a possible downgrade wave coming. CLO managers mentioned that they are rotating up into higher-rated single-B loans, and also some double-B credits, to avoid potential downgrades to triple-Cs.
Increased dispersion
Even if the CLO market has not yet seen the full extent of volatility in the loan market, performance dispersion is becoming increasingly pronounced across CLO portfolios, and a re-tiering of CLO managers is underway, panelists told the conference. The dispersion is mostly being seen in equity NAVs and double-B MVOCs, panelists said, with one panelist stating that they saw “up to 600 basis points of dispersion for double-B MVOC”, and “up to 10% in equity”.
One speaker on the CLO investor stack panel stated that the headline average double-B attachment point for US CLO double-Bs is just under 8% (new issue double-Bs price with 8%-8.5% of par subordination), but for distressed double-B tranches that figure is closer to 6%, a full percentage point down from last year.
Another panelist stated that this can give some opportunities to buy, however, stating that the bottom 10% of double-B tranches by MVOC are uncovered and trade with a 10-20 point discount on the secondary market. This models out to cash yields that are similar to new issue equity, while some lower-rated triple-B tranches are reproducing returns similar to those of CLO double-Bs, something which had not been possible to buy in the secondary market in a long time, they said.
It is not just dispersion across managers, as CLO tranches are also differing in performance. Against the backdrop of declining MVOCs and NAVs, US CLO triple-As quietly had an excellent March. One panelist said US CLO triple-As “were about the only thing we owned that had a positive return in March”, stating that triple-As returned 20bps-30bps of positive returns in March, compared to IG corporate bonds which was -2% in the month.
Triple-A performance is not expected to vary wildly from manager to manager, and even triple-A spreads between tiers are expected to remain within a small range, panelists said, with good demand from banks at the top of the cap stack. Triple-As could also benefit from the new NAIC proposals for insurer buyers of CLOs (more on that later).
As mentioned, times of volatility often lead to a re-tiering of CLO managers, with one investor saying that “performance will be reflected in the equity returns”. They went on to say that the managers with the best performance at the bottom of the capital structure will be “incredibly active in portfolio management, have proper credit selection at the outset, and produce consistent, predictable cashflows but also maintain and preserve the principal value of the portfolio to keep options open for equity.”
Already, that re-tiering is under way as one speaker on the secondary market panel said that the managers they consider tier one currently have been outperformed. They stated that “we have 11 managers in our ranking that are tier one, but they saw a larger drop in double-B MVOC of any tier two. The tier one managers had 1.8 points of MVOC decline from January to today versus our tier two managers which saw only a one point drop.”
Captive equity and the future of third party equity
A big focus of the CLO conference this week was the performance of CLO equity, and specifically captive CLO equity funds. Captive equity funds were raised to give CLO managers more flexibility to issue CLOs in periods of market dislocation, when CLOs have a proven track record of excelling, but can struggle to get a third party equity investor on board.
However, captive funds now dominate CLO issuance as CLO equity has become a victim of its own previous success, one speaker stated. Around 75% of new issue equity last year was placed into a captive vehicle, as the arbitrage did not look particularly attractive to typical CLO equity investors with repricing waves taking spread from the market when most loans were still trading at or just below par. On top of this, defaults rose to 4%, double the historical average, yet CLO issuance last year was a record high as CLO managers had captive funds to call upon.
However, as one panelist said “CLOs are supposed to be issued when the arb works, not ‘if we take 10 deals the arb will average out’”. It is no surprise then that CLO equity performance last year was awful, with one panelist stating that several research desks showed the asset class to be down 32% on average. A remarkable return considering all CLO debt classes achieved positive returns last year. Still almost every US CLO manager has a captive equity fund, and these funds have investment limits which means the managers need to put the capital to work, and potentially continue issuing uneconomical deals, several panelists told the conference.
So what is the future of the CLO equity asset class? One traditional CLO equity investor believes that third party CLO equity investors still have an important role to play in the market, but they are fighting a losing battle. They stated that “some corners of the market has been convinced that CLO equity is okay to return 10-12% or even 7-8%, but that’s not the correct math. CLO equity is a first-loss position, that has all of the risk, and is 10x levered. Returns should be 15%-plus.”
The investor continued, saying that “we really believe in diversification and separation of church and state and decision-making and alignment of interest, and really fighting for the best interest of the equity and not just printing for fees and AUM.”
Panelists finished by saying that when these funds reach maturity, some CLO managers will have to answer to their LPs, but those conversations are being kicked down the road for now. However, there are signs that CLO captive equity funds could struggle in the future. Several sources have told 9fin that fundraising for these vehicles has slowed considerably, and a lot of managers trying to raise capital for equity funds are struggling to do so.
Relative value across CLOs
The CLO market has been compared to a cruise ship turning in a canal before, as the pace of movement can be slow at times. But recently, market dynamics have been shifting much quicker, sources say.
As recently as three weeks ago, the US CLO primary market was practically shut down and several investors had backed away because of AI volatility and the war in Iran. However, things have changed quickly — CLO primary liabilities are now tightening, and deals are being launched at a greater pace.
Investor panelists mentioned that they viewed the US CLO primary market as more attractive than the secondary market currently as a new issue has less tail in its portfolio, but both deals would be trading at similar levels. Short refinancings in the primary market are also attractive to some panelists as spreads in the refis are in some cases wider than 5/2 new issues as the term curve has flattened out or inverted.
As resets have become much more expensive for managers to price, due to the cost of injecting capital into the deal to trade the portfolio, more and more refinancings are expected to hit the market. However, the investor depth at 3/1 tenor is much thinner than at 5/2, which could cause oversupply and saturation in the market, and even wider spreads for investors in the refinancings, panelists said. On top of this, often investors can squeeze some basis points out of managers in a refi as long as the deal stays in the money — in new issues, this is much more difficult, they said.
There are still opportunities in the secondary market, as mentioned earlier, and liquidity has not been an issue for the market. One panelist stated that the first two weeks of March were the two largest TRACE trading volume weeks in the history of the CLO market as dealers remained open. This was not panic selling however, as the panelist stated that several investors took advantage of CLO prices holding in on the secondary market, to sell out of CLOs at par, and rotate into other asset classes that sold off more.
This was not true across the CLO capital structure though. CLO equity has been especially tough to source, several speakers mentioned. This was due to a combination of factors including sellers not wanting to sell at the distressed prices, but also that most CLO equity these days is sold to captive funds which don’t sell or trade positions, panelists said.
NAIC update
As 9fin has covered recently, the NAIC and Academy of Actuaries are revising the capital charges for US insurance companies that buy and hold CLO tranches. The anticipated, forthcoming capital charges are expected to reduce the cost for insurance companies to own triple-A, double-A, and single-A CLO tranches, but increase the cost of owning triple-B, double-B, and equity tranches. Insurance companies are the biggest buyer of CLO triple-B tranches, so this is expected to shift insurers demand in CLOs, and could lead to triple-A tightening, sources say.
There is no guarantee that insurance companies will rotate all the way up to triple-As, however. They may target double-As and single-As where reduced charges are incoming, panelists said. But if insurers start taking down the majority of those tranches, and push them tighter, then traditional buyers of double-As and single-As could rotate up to triple-As and take the extra protection at a slightly lower coupon, sources say. All this to say, that CLO debt could grind tighter off the back of the new capital charges.
Retail access growth
While insurers remain the dominant structural buyers, retail participation via ETFs has been increasing on the margin, though the overall pool was still smaller than the broader CLO market, with inflows into CLO ETFs representing around 10% of the new issue.
One speaker said liquidity in these CLO ETFs was more robust than expected and that they saw minimal dislocations during the Russia-Ukraine invasion and last year’s Liberation Day. In addition, the ETF in-kind redemption process meant there was no fire sale of the underlying CLOs when investors pulled money out of these funds.
Still, the rapid growth of these investment products should not be underestimated. One source noted that inflows into CLO ETFs had substantially improved liquidity in the triple-A tranche, allowing managers to lean on that part of the market and print higher-quality structures.
Additional retail participation could come through employee retirement accounts like 401ks. That could be stymied, however, by 401k plan sponsors’ concerns about potential lawsuits related to higher fees.
To that end, one speaker noted that legal cover from the Department of Labor could prove helpful, similar to the landmark rule recently proposed by the DOL for private credit and alternative assets.
