Fuelled by a blockbuster year in the US, the global CLO market hit the milestone of $1tr outstanding in August 2021. It had been a hard road for the asset class since the global financial crisis in 2008, but it was reaching a size where it could not be ignored.
Another year of progress beckoned in 2022, but Russia’s invasion of Ukraine — along with higher inflation and rising interest rates — meant any hopes that 2022 could surpass 2021 were quickly dashed.
The US CLO market had over $400bn of issuance last year, according to data from Finsight, with about $180bn of that coming in the form of new issue CLOs. So far in 2022, only $110bn has been issued overall, while the final figure this year is expected to be around $130bn.
“2022 has often felt like a slower year given the bouts of volatility, but it really isn’t,” said Sean Malone, managing director at rating agency KBRA.
Indeed, the numbers from 2021 are slightly skewed by the pandemic-induced shut down of supply in 2020 that left the market with lots of pent-up demand and great opportunity to refinance or reset deals. Taking into account the broader historical context, issuance has remained quite strong, Malone said.
“If you see the full year round out at around $130bn, that’s above average.”
Robert Villani, a partner at law firm Clifford Chance who specialises in structured credit, tells GlobalCapital: “The flow of refinancings and resets slowed and then stopped, but certain managers continued to be able to price new issue broadly syndicated CLOs.”
He adds that Clifford Chance is still working on new warehouses for future CLO issuance, suggesting that supply will continue.
Volatility hitting CLO construction
While the US CLO market is more removed from the war in Ukraine and has a much deeper investor base than its European counterpart, the knock-on effects of the war still drifted into market conditions.
Spreads on triple-A rated US CLO notes in the secondary market had been steady throughout 2021, hovering just above 100bp over the benchmark. Following Russia’s invasion on February 24, they rose quickly to 130bp. By late July, spreads briefly went above 220bp, according to data from Prytania Solutions. As of the end of September, the spread is 203bp, 84bp wider than at the beginning of the year, and ticking upwards once again.
The heightened volatility in spreads also meant it became more difficult to construct new issue CLOs. As an arbitrage product, CLO construction is something of a balancing act to make deals economical for investors throughout the capital stack as well as for the CLO manager. As widening spreads on the triple-As trickled down into widening across the structure, it made it much harder to convince equity investors to get on board.
In addition, US bank investors who were typical buyers of triple-A CLO notes have stepped away from the market, leading to one US banker wondering if the US CLO market had relied on their support too heavily.
However, the absence of US bank investors was largely due to capital treatment regulations. KBRA’s Malone adds that insurance companies, frequent investors in the mezzanine tranches, are also starting to look at how investing in CLOs will impact their capital requirements.
On the other hand, Japanese investors who had been absent in the triple-A US CLO market appear to be returning.
“Japanese investors are back into this market, filling some part of the void left by the US banks,” one CLO investor says. “So, there’s adaptation capabilities and arbitrage opportunities meaning deals are getting done.”
Maturity is the word
Although deals continue to come through, S&P Global said in August that negative sentiment in the US market had “increased markedly”, making investors and issuers “wary” of corporate downgrades.
Despite this, S&P’s stress tests that mimicked the global financial crisis in 2008 and pandemic-driven recession in 2020 found 93% of triple-A rated CLO notes saw no more than a “one-notch downgrade even in our harshest scenario”.
This confidence is reflected in market participants as well. They are convinced the asset class will remain attractive to investors and resilient to any economic downturn.
The buzzword behind that confidence is the “maturity” of the US CLO market.
Eric Hudson, senior managing director and head of structured credit ratings at KBRA, says that the last couple of years of innovation and evolution in CLOs meant there was now a “longer menu of options” that CLO managers had to choose from to accommodate choppy conditions and different investors’ needs, making the market “resilient”.
Malone says some of the changes in CLO structures this year had often been “protective” moves, unsurprisingly perhaps as issuers tried to navigate volatile market conditions, but there were still a lot of different tactics being deployed.
“[Some of these are] shorter reinvestment periods, non-call periods, more par subordination across the structure, flipping static versus reinvesting,“ says Malone. “Similar structural mitigants were introduced at the onset of the pandemic and although structures continue to evolve… they’re not as creative or innovative as some of the things we've seen before.”
Hudson agreed, and said there was less “consistency” from deal to deal. However, issuance volumes were still historically quite high.
Similarly, Villani sees the bigger menu as a positive. “I believe this is a sign of the asset class's maturity and strength, as in prior difficult markets CLO issuances completely stopped rather than just slowed down,” he says.
Meanwhile the CLO investor says the US CLO market had proven to be a “surprisingly resilient” asset class. Much of that resilience stems from the history of CLOs. The sector has seen off the global financial crisis, the European debt crisis throughout the 2010s, the Covid-19 pandemic and now a mixture of the war in Ukraine and rising inflation and interest rates.
“The market is now pretty mature and they’ve been through a lot,” the investor said. “It’s no longer one product, it’s a range of products and you see that every week.”
CLO 3.0 could already be here
Looking ahead, a CLO manager in London says US CLOs will fare much better than European products.
“The US economy is performing better than the conglomerates of European economies and in that market there’s less nervousness and the arbitrage is, without doubt, significantly better than in Europe.”
Meanwhile, there are murmurs that CLO structures could be close to a permanent shift into what will be known as CLO 3.0.
A banker told GlobalCapital that as higher interest rates and inflation become more entrenched in global economies, it will lead to securitization structures adapting en masse in how transactions are structured.
Villani goes further, saying that we may have already seen CLO 3.0 following adjustments made post-Covid. “My sense is that the investors and rating agencies are still digesting those,” he adds.
With the war in Ukraine still raging and rates still rising, the next few months are likely to continue to be volatile. However, CLO market participants remain confident the sector will stand firm come what may.
