1Q22 US CLO Wrap: Macro worries slow 2021 market momentumMarch 25, 2022
Going into 2022, the Libor-to-Sofr transition was seen as the chief obstacle to primary CLO deal issuance. And indeed, as many market forecasts projected, the US CLO market had a sluggish start to the year ($4.91 billion in January primary volume) as managers looked for established pricing parameters to take root with the replacement benchmark.
That lull was short-lived, however, as the market rebounded in February with $14.26 billion in freshly printed deals, and analysts believed momentum from the record-breaking 2021 ($186.7 billion) would carry on, what with more than $100 billion in warehoused loans awaiting placement in CLO vehicles.
But over the past month, macro worries regarding inflation and Russia's Feb. 24 invasion of Ukraine—and its cataclysmic impact on global financial markets—have returned the CLO market to a state of uncertainty.
Through March 22, only $8.31 billion of new-deal activity had taken place this month. Some managers are pricing short-dated deals, willing to accept wider spreads, or even including rare make-whole provisions to entice buyers to the market. Others are biding their time.
"We have long-term warehouses now ready to market," said Ivo Turkedjiev, managing director and portfolio manager at New Mountain Capital. "But we are just going to wait for the conditions that make sense for us to hit the print button."
"There are plenty of managers that want to go to market and get a deal done," added Derek Dubois, managing director and treasurer for Deerpath Capital Management, which issues middle-market CLOs. "But it's a matter of 'when does it restart, and at what levels?'"
"Everyone realizes it's going to be more expensive, at least for the short term. I would estimate [terms] are 10 to 20 basis points wider than [they were] two weeks ago."
The $27.5 billion of primary CLO volume so far this year falls 27% short of last year's pace of $37.5 billion through March 22 (the final 1Q21 tally was $39.8 billion) and ends a streak of four consecutive record quarters. It was the lowest output since the third quarter of 2020.
The slowdown in the primary market has hit resets and refinancings, too. According to LCD data, only $4.5 billion in refinancings across 11 deals and $15.2 billion in resets across 27 deals priced during the quarter through March 22.
Nearly all of that repricing activity was relegated to the two months prior to the outbreak of the Ukrainian conflict. No refinancings or resets took place after Feb. 28 until Owl Rock Capital reset an upsized a 2020-vintage CLO at a spread of Sofr+175 bps on March 21.
Spreads continue widening
With volume falling, BSL CLO AAA spreads widened during the quarter, with an average coupon of Sofr+135 for top-tier managers pricing full five-year reinvesting deals. That compared to Libor+116 during the fourth quarter, indicating price softening beyond the average 8-10 spot basis-point difference between Libor and Sofr during the first quarter through March 11, before the gap between Libor and term Sofr widened to the 30-40 bps area.
Sofr-benchmarked AAA spreads were as narrow as 129 bps in January, but by mid-March, "AAA CLO spreads look to have widened out with coupons of Sofr+138/140 for benchmark managers and discount margins not being released," noted Deutsche Bank in a March 15 credit research report.
According to LCD, BSL CLOs were pricing at an average of nearly 142 bps over term Sofr for deals pricing the week of March 15-21, including short-dated deals and even those with uncommon investor incentives, such as make-whole call provisions.
Market analysts noted that managers had more difficulty pricing mezzanine and junior tranches during the quarter.
Most believe the credit-widening trend is fed by macroeconomic uncertainty, as well as heavy activity in the secondary CLO market. J.P. Morgan noted in a March 21 research report that average AAA BWIC volume in the year-to-date is $709 million, compared to $259 million in 2021.
CLO equity holders, who were already expecting to face NAV (net-asset value) pressures on the Libor-to-Sofr transition, have also experienced falling cash flows during the quarter. The loss of income was two-fold: the erosion of cash flow from the deterioration of Libor floor protections as Libor rates increased; as well as from a growing gap between one-month and three-month tenor that is prompting borrowers to switch their benchmark rate to the lower one-month rate, according to BofA Securities research.
The 48 bps gap between the two tenors invites borrowers to switch to one-month Libor to reduce monthly obligations, resulting in less cash flow for the subordinate end of the vehicle, as equity owners continue paying notes to the three-month Libor rate.
The slowdown in the CLO market ran in parallel with the first-quarter retreat by loan issuers. Loan volume fell to $36.8 billion in February and March, after a rocket-like start to 2022, featuring a record $72.67 billion in loan issuance in January.
The market uncertainty caused the weighted average bid of leveraged loans to fall to 95.88 on March 15, losing 244 bps in 30 days, before bouncing back to 97.19 by March 22. For reference, the average stood at 98.03 on Feb. 23, just before Russia's invasion of Ukraine.
Institutional loan volume fell to its lowest level since the fourth quarter 2020, and dropped for a second consecutive quarter. to just $109 billion as of March 22, after $125 billion of activity in the fourth quarter of 2021 and $157 billion in the third quarter. First-quarter M&A-related supply of $73.7 billion marks a four-quarter low, down from $77.9 billion in the fourth quarter.
Manager consolidation wave
With fewer deals in play, fewer managers were active during the quarter. Just 42 managers priced new-issue deals through March 22, compared to 57 at this point a year ago.
The manager tally in 2021 was an all-time high of 124. That may be difficult to reach again. Not only has 2022 gotten off to a relatively slow start, but a wave of manager consolidations have swept across the market.
On March 9 The Carlyle Group announced its plans for a $787 million acquisition of CLO management firm CBAM Partners, a move that will propel Carlyle into the largest shop by asset volume in the CLO industry.
The Carlyle-CBAM deal was followed shortly by the news on March 19 that AllianceBernstein agreed to acquire CarVal Investors for $750 million, shifting CarVal into a wholly owned subsidiary of AllianceBernstein, to be rebranded as AB CarVal Investors.
Blue Owl Capital in February agreed to acquire Wellfleet Partners LLC, a CLO franchise of affiliates of private equity firm Littlejohn & Co., for an undisclosed amount, while T. Rowe Price closed in late December on a $4.2 billion acquisition of Oak Hill Advisors.
KKR was reportedly among parties in January expressing interest in buying BNY Mellon's Alcentra credit unit, which has $43 billion of AUM, including CLOs.
Even with the merger wave, the headcount of managers in the marketplace continues to grow organically. During the quarter, RBC-owned BlueBay Asset Management—a global alternative assets manager with $120 billion in assets—priced its inaugural US CLO vehicle (BBAM US CLO 1) with seed money from Apollo Global Management.
In addition, an advisory unit of Franklin Templeton (Franklin Advisers) re-emerged from a 10-year absence in the CLO market to price its $393.1 million Franklin Park Place CLO 1 deal.
Copenhagen-based Capital Four in January closed its US market debut CLO that priced in December, and expects to price at least one more deal before the end of the year.
"We don't want to rush out and try to do too many things all at once," Capital Four US CEO Jim Wiant said in a January interview with LCD. "We recognize in your early stages, in particular, getting your performance right is critical."
The depletion in Libor floor protections and the widening 1M/3M Libor gap presents fresh headwinds for equity. But 2021 was a boom year for CLO equity—and its third-party owners. Record volumes of resets and refinancings left them flush with cash to strengthen positions in 2022.
Eagle Point Credit Co., for example, closed the fourth-quarter of 2021 with $31.1 million in cash reserves after refinancing or resetting 34 CLOs controlled by the firm. CEO Tom Majewski said in February that Eagle Point plans "to be actively working on the [reset/refinancing] pipeline throughout much of 2022."
Market observers are optimistic that normalcy will soon return. Corporate defaults in the loan market are still pacing behind 2021 levels, and the first of several Fed interest rate hikes at the March 16 FOMC meeting will boost fixed-income demand and "will help floor US CLO downside sooner than later," according to J.P. Morgan's report.
Serhan Secmen, a partner and head of CLO investing at Napier Park Capital, believes the market "will find its footing" as the Fed's actions are "eventually going to unlock the staring contest in the market."
"There are still various short-term risks on the horizon, however I expect momentum will likely pick up by the second or third quarter if these [risks] start to subside," he added. "There's so much money [in the market] waiting to invest, that is true. Yet nobody is in a hurry. They can afford to wait a week, a month, three months. Eventually it is going to happen."
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