The challenges facing the CLO market

Collateralised loan obligations have stood up under stress before, but conditions now may be more demanding than ever.

We undertake an in-depth exploration of the CLO market in our upcoming December/January issue. Here are five of the takeaways:

1. The days of easy money are over. It’s anybody’s guess when they will return. Although the $1 trillion market for collateralised loan obligations has a track record of performing well through credit cycles, including the global financial crisis, a confluence of stresses that weren’t present during the last big liquidity crunch could well make this time different. Participants throughout the credit markets are on edge, trying to jockey for position amid slowing economies, rising interest rates, stubbornly high inflation, a looming energy crisis in Europe and the war in Ukraine.

2. Record-low interest rates created “a starvation for yield that fed into a huge appetite for people buying CLO equity at a fraction of the appropriate price and that was, most importantly, out of alignment with the CLO managers who have no skin in the game”, one source told us. But it isn’t just the buyers of CLO equity and lower-rated debt whose interests aren’t aligned with the managers. Other misalignments in the ecosystem include CLO managers who provided inexpensive and overly permissive leveraged loans to PE sponsor/borrowers, who in turn had raised capital from limited partners and paid record multiples for leveraged buyouts with high-multiple, floating-rate debt that will now be difficult to refinance and that will make delivering appropriate equity returns “extraordinarily challenging”.

3. Deep-pocketed asset managers like Apollo stand ready to pick up highly rated assets on the cheap, as Apollo did when it took $1.1 billion of the UK pension funds’ $1.5 billion of triple-A rated CLO debt off their hands in the October selling frenzy. Apollo’s co-president Scott Kleinman said on the company’s earnings call that Apollo’s purchases were made at an effective 8 percent yield, relatively high for the safest CLO debt.

4. The CLO market today is “nowhere near as pessimistic as it was in 2016”, when double-Bs fell below 70 cents on the dollar. Today, they trade in the low 80s on the secondary market. Markets have been relatively orderly thus far but “there’s a tremendous premium on credit selection, and market dislocation and higher volatility will expand the opportunity set”, we were told. “Lower priced assets are going to go a lot lower.”

5. Investors are starting to look for yield and safety in the more liquid fixed income markets. An October poll by consultants bfinance found that 24 percent of UK investors expect to reduce their private market exposure over the next 18 months, while those expecting to increase their fixed income exposure rose from 25 to 29 percent. “The classic thing I hear from people trying to put deals together is, ‘why would I do this, when I can buy an investment grade public issue at the same price?’,” a source said.

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