This article is sponsored by Schroders Capital.
The US and European leveraged loan markets have so far held up well through a period of macro uncertainty, but there is concern over the magnitude of the default cycle coming. What are your thoughts on the outlook?
Leverage loan default rates have already begun to pick up and we expect them to rise through 2024, likely to hit 4-5 percent, with some risk of going higher still. As a result of higher defaults, the equity classes of CLOs will be the most directly impacted. Defaults and lower recoveries will have the potential to threaten junior and mezzanine classes of CLOs with interest deferrals and potential principal losses. Even at those higher default rates, however, some CLO classes are well protected.
The surprise in this credit cycle will likely be the much lower recoveries of defaulted loans; a recovery of 30-40 percent instead of the historical average of 70 percent. Even when looking at recent recoveries, there are some notable low numbers, but averages remain fairly high (slightly below historical levels). However, this is a bit of a smoke and mirrors game, as those recoveries are only based on the defaults that have resolved – they do not include the future, likely much lower recoveries on loans that are not easily resolved.
CLO classes such as the senior (AAA) and AA class are protected to withstand much higher default rates than those expected. In addition, classes such as BBB and BB appear to be able to withstand even these higher default rates, but much of that analysis is based on historical recoveries, which have been very high. When that analysis with higher defaults is re-done using a lower recovery rate, we expect those investors will feel they own a lot more credit risk than they expected.
We have a simple rule for these BBB or BB CLO classes, “par is never the right price”. We expect to see some big discounts in those CLO securities as we roll through this credit cycle, and would look to assess opportunity when the price is right.
How do you see different parts of the CLO structure offering protection or opportunity through a default cycle?
Current loans, as represented by the index average, are trading at a discount price, $95-$96. This number was lower even earlier in 2023, but it is worth keeping in mind the trick with that average. In fact, the index consists of two groups of loans, loans at par and loans at a more material discount. Most of that average discount is coming from a growing population of CCC-rated or distressed credits, which is not the population that CLOs generally buy.
Loan spreads, on the loans CLOs will hold today, are relatively tight compared with where the CLO itself will place (issue) debt. So, the arbitrage feels a little tight now. If you layer on top of that an increased expectation for credit losses, it can feel stretched.
Where does that put a CLO equity investor? They really have to take a view on the talent of their manager and the potential for them to create credit gains during the reinvestment period of the CLO structure, so creating more value trading through the credit cycle. Some have a history of doing this, some do not.
We have actually found the Leveraged Loan Index to be ‘disturbingly’ stable. CLOs come in as buyers when loan prices go down and as the owner of two-thirds of the leveraged loan market, CLOs are also very solid hands (like a closed-end fund they are not forced to sell).
As such, they provide a unique level of support to loan prices. CLOs provide such an important backstop that the leveraged loan market index only takes a large dip when CLO issuance is on pause. That has made it a particularly difficult index to outperform, frankly.
What is the importance of a manager’s style and approach when it comes to CLOs?
CLO managers each definitely have a style as to how they approach their credit work and how they manage the credit risk in their CLO portfolios. Some managers are high conviction. High conviction managers take credit views that well selected ‘weaker’ borrowers will find a firmer footing and so profit from that improvement.
Other CLO managers, ‘credit rotation managers’, try to stick with stronger credits and are quick to rotate out of them on weakness. These high-quality managers might take small losses but perhaps a little more frequently.
In general, high-conviction managers are more favourable for CLO equity-style investments and credit rotation managers are more favourable for senior CLO investments, but managers that have a long history of low credit losses are attractive for both.
We often see managers that struggle with a break from the historical performance/past style and for us, that is a sell signal. We feel willingness to be a transparent partner is key in choosing a CLO manager. Through the years we have got to know many experienced, talented managers in the CLO universe. It is easy to build diversified CLO allocations with the best-performing partners.
Are there any changes in the market that you are observing?
The equity class of CLOs is often among the hardest CLO exposures to place – it is the most directly exposed to credit losses. Market players want alignment of the manager, in particular in equity positions.
Currently, many managers are trying to source their own equity, either in-house or through dedicated marketing. There is little appetite from investment banks to ramp up a portfolio of loans for new issue without equity capital in place. Given this BYOE (bring your own equity) market condition, more favourable terms are likely to develop for those with the capital available to partner.
We find things that are seen as ‘boring’, like senior classes, quite interesting. US and Japanese banks have historically been big buyers of the senior (AAA) class and more recently have been less active, or have had fits and starts of activity. This has been creating some pockets of especially wide spreads that have been good buying opportunities. Over 7.5 percent yield for AAA-rated low duration securities is an attractive headline.
Other areas called ‘new’ are not really new. The private credit CLO market that has been getting a lot of attention isn’t new. Mid-market CLOs backed by smaller borrowers have been around for decades and have never found the same traction as those broadly syndicated loan CLOs based on fully syndicated bank-style leveraged loans.
Private credit CLOs are basically mid-market CLOs with new branding that seem to be getting fresh energy. It’s a bit like iPhone 8 and iPhone 9, neither of which is an iPhone 15.
How does the structure of the US CLO market differ from Europe?
The dominant market in the US is bank-syndicated leveraged loans, which is among the largest credit markets globally, and with CLOs approximately two-thirds of that, CLOs are among the biggest securitised credit asset classes. The US bank-syndicated leveraged loan market is huge, worth $1.4 trillion. The European market is about one-quarter of the US market, about $350 billion, and the mid-market space is much smaller.
We invest in and assess both European CLOs and US CLOs. We often have a preference, in some cases due to our economic views on the regional differences. Sometimes we prefer owning euro to US dollar investments (or vice versa) and we’ve found the economic cycles between the US and Europe are not exactly correlated and, furthermore, the EU and US CLO markets are not necessarily correlated.
Principally, European CLOs have different investor dynamics. Many EU investors have difficulty investing in US CLOs for regulatory reasons, so European investors may focus solely on European CLOs. We like to look at the relative value and pick our spots. Right now, we like European CLOs at the very top of the capital stack.
As one of the original CLO structurers in the 1990s, how would you describe the evolution of the market to date and what might we expect to see around the corner?
The CLO market has undergone a major maturation since I started. Since the late-1990s, CLOs as an asset class have been through two major recessions, first with the bursting of the tech bubble in the early 2000s and then the global financial crisis in 2008. These were both major tests for the structure. Interestingly, the first test was actually a bigger challenge than the 2008 GFC, but from where we sit today, CLOs feel like a proven asset class.
The other change is the scale of CLO issuance. It is second only to auto asset-backed securities (if you exclude agency MBS) within the securitised space. This volume means CLOs are often a normal part of investors’ fixed-income credit portfolios, or credit portfolios; they are attractive to corporate credit managers as well insurance companies.
What do I see around the corner? I see opportunity. It is going to come as we move through the next default cycle and as the disappointment gets registered in leveraged loan recoveries. Whenever consensus resets expectations, you can expect some repricing and opportunity as nervous buyers (and tourists) sell, leaving the alpha to those that remain to buy.
From investors that find the change in recoveries a surprise, we will see some selling and that will create a nice opportunity. With the default cycle, there is going to be a lot of CLO debt trading at 80 cents on the dollar and recovering at par, creating some very attractive entry points.