Appetite for CLOs expected to remain strong amid risks of inflation, rising rates

Fundamentals of floating-rate investments, which have driven record CLO issuance, will keep attracting yield-hungry investors, says Western Asset Management.

Wariness surrounding inflation and rising interest rates are pushing investors into more floating-rate debt, and should drive investor appetite for the white-hot CLO market, market participants say.

“We expect to see a greater appetite for floating-rate investment grade paper, which will maintain the strong appetite for CLO liabilities and drive continued CLO issuance,” said Ryan Kohan, head of bank loans at Western Asset Management, in the specialist investment manager’s recent call with portfolio managers.

A rising interest rate environment is typically very supportive of demand for floating-rate loans, which is driving the market, the manager said.

Loan mutual funds, Kohan believes, will also continue to experience inflows from investors who are looking for limited duration, attractively yielding products.

“Underlying loan fundamentals are currently very strong, with healthy cash flow coverage, so we see ample cushion for borrowing costs to potentially rise,” Kohan said of companies’ ability to pay debt burdens with their cash flow. The current broader market’s cashflow coverage is 3.6x, compared with the under 2.0x managers saw during the global financial crisis, he said.

What is also driving confidence for Western Asset on loans is investor demand for returns.

“Record CLO issuance this year has been driven by both investors’ demand for floating-rate investment grade paper as well as the attractiveness of new issue CLO equity returns,” Kohan said.

“Those equity returns remain attractive due to bank loan spreads remaining wider than pre-covid levels,” Kohan noted in the call, despite the cost of financing for CLOs coming in tighter. He added that supply and demand conditions are balanced as a result of new loan issuance this year.

The US CLO market hit a new issuance record earlier this September for the third consecutive quarter, with deal volume surpassing $43.6 billion, topping the previous high of $43.4 billion in the second quarter, according to S&P Global Market Intelligence’s LCD.

In Western Asset’s An Investor’s Guide to Collateralized Loan Obligations (CLOs) whitepaper published earlier this June, the manager notes CLO vehicles at that time owned 60 percent of the $1.2 trillion bank loan market, with the balance being owned by mutual funds and institutional entities.

“Much of the growth in the CLO market can be attributed to a continuously expanding investor base consisting of large banks, both foreign and domestic, insurance companies and asset managers,” Western Asset writes in the white paper. What is drawing investors to CLOs is diversification benefits, strong historical performance and attractive relative value, they say.

Western Asset is the specialist investment manager of global investment manager Franklin Templeton. The manager has invested exclusively in fixed income since 1971 and oversees more than $491 billion in assets for institutions and individuals on six continents.