Middle Ground in Bifurcated Loan Market to Determine CLO Returns

 

The first half of 2024 was a bull market for CLOs with new issuance in the US reaching $101 billion, up over 75% from the same period in 2023, according to Reorg’s CLO issuance data. Expectations of higher-for-longer interest rates combined with a benign economic forecast of a soft landing in the US pushed investors into floating-rate products.

Cash-flush CLO managers bid up the loan market, with upwards of 60% of the loan market traded above par at various points during the first six months of this year. Meanwhile, spreads on CLO liabilities ground to multiyear tights, as evidenced in the chart below sourced from Reorg data:
 

While higher secondary loan prices juiced returns to CLO equity investors during this period, it created challenges for managers looking to print a CLO in the new issue market. Managers looking to raise a new CLO prefer assets priced at a discount, in order to benefit from a pull-to-par effect over the lifecycle of the CLO.

With a record share of the loan market trading above par, managers had two other pools from which to source loans at cheaper prices. One is to recycle collateral from older CLOs that were called, as CLO call volume also reached records in the first half of the year. The second is the slice of the loan index that trades in the 85 cent to 100 area.

While loans in the 85 to 100 price window are most attractive to managers structuring a new CLO, this segment of the market has been shrinking as the year progresses and only accounts for around 10% of the index as of early August. Most of the market has bifurcated, with stronger credits trading up over par while weaker ones move down to distressed levels.

Some CLO tranche investors have expressed concerns around the fundamentals of loans in the 85 to 100 price window and question whether managers’ reliance on the dwindling pool of loans that fall within this bracket is storing up problems for the 2024 CLO vintage in the future. As one CLO debt investor told Reorg, “If it isn’t trading above par, you have to question whether there’s something wrong with it”.

Sources worry that credits in this group are at greater risk of being downgraded to triple-C or enter into a liability management exercise in the future – these two outcomes being the preeminent fears of participants in the CLO space. Moreover, as the market confronts the likelihood of interest rate cuts in the second half of 2024, these credits could see their price more severely impacted once market technicals no longer favor floating-rate investments.

“These could be loans that have a triple-C rating but the market is trying to showcase through pricing that it isn’t triple-C type risk” says Ian Gilbertson, co-head of US CLOs at Invesco. “Another group is names that are B3 or B- that a handful of lenders are reducing because of concerns around it deteriorating to triple-C-type risk, and is potentially the next shoe to drop.”

“Sectors like theater, telecom or cable that have clear secular headwinds are also drawing into this basket” Gilbertson adds. “A lot of managers see one large company get downgraded and look to reduce exposure to its competitors in the space if it can be done in the 90s”.

Reorg has compared loans trading in the 85 to 100 bracket at the end of the second quarter to the broader Credit Suisse Leveraged Loan index by a range of metrics to assess fundamental quality over the previous four quarters.
 

Loans priced between 85 and 100 have shown consistently lower pro forma EBITDA growth in each of the last four quarterly reporting periods. Although the spread between these credits and the portion of the index trading at a premium to par was larger in the first half of 2023, there was 3.2% separating these two cohorts during each of the past three quarters. While this metric has been declining modestly across the index, loans priced over par posted 8.2% growth in their first quarter 2024 results compared to just 5% for loans priced over 85.
 

Comparing the two groups of loans by looking at last twelve month revenue growth tells a similar story, with the cheaper loans consistently displaying lower growth than the over-par group, although once again the differential has narrowed over the previous year. Revenue growth for loans priced over 100 has declined from 10.1% in the second quarter 2023 results to 5.2% in the first quarter of this year, while for loans over 85 the numbers fell from 7.5% to 3.5% over the same period.
 

The cheaper cohort of loans has higher [first lien] leverage than the cohort that trades above par, although this metric has shown little volatility over the past year. In the most recent reports, loans in the 85 to 100 price window had 4.1 turns of [first lien] leverage, while the more expensive segment of the index had 3.7 turns. The over-par loans also saw their leverage ratio dip to 3.5 turns in the last report of 2023 and this reduction did not occur in loans between 85 and 100.
 

Loans trading between 85 and 100 also reported lower free cash flow than loans trading above par. Free cash flow yields for the cheaper group increased from 1.7% to 1.9% from Q2 to Q3 of last year, before decreasing to 1.5% where the metric remained for the next two quarterly reports. Notably, free cash flow for loans trading over par has shown more variation over the previous 12 months. This cohort saw free cash flow yields reach 3.6% in the Q3 2023 reports, but dropped to 3% the following quarter and by the time of the 2024 Q1 reports free cash flow yields dropped to 2.9%.
 

The cheaper loans have lower interest coverage ratios than loans priced over par, although the spread between the two price cohorts has remained consistent over the past four quarters while interest coverage ratios across all loans have decreased modestly.

Loans trading below par but above 85, which are caught in an ambiguous middle between the performing and distressed categories, are expected to be the key determinant of CLO returns as they will have a meaningful impact on where default rates end up over the next several years. Many have idiosyncratic business concerns but most are experiencing cash flow problems because of higher interest rates, although that pressure could begin to ease soon if the Federal Reserve begins cutting interest rates from September.

Several CLO managers told Reorg that the sub-85 group, trading at distressed levels, do not pose a significant risk to CLO returns as a certain amount of pain is already priced in, and while there could be surprises hiding among credits trading over par, they are generally the higher quality assets in the loan universe. Loans trading at a premium to par are also less appealing to managers looking to ramp a new issue portfolio.

The other key source of collateral in the new issue market is recycled loans from CLO portfolios that have been liquidated. A CLO tranche investor source told Reorg that several of the new issues in the second quarter of 2024 ramped using collateral from called CLOs as the core of a new issue portfolio which was then supplemented by loans trading in the 85 to 100 cent area.

According to representative data from Moody’s, 24 CLOs holding a total of $6.14 billion leveraged loans were called in the first half of the year. A list of called CLOs can be viewed in the table below, while the portfolio of each deal in the table can be explored in Reorg’s CLO database.
 

Source: Moody’s

The volume of loans trading above par has boosted the number of CLO calls in 2024. A significant portion of legacy CLO vehicles had left their reinvestment periods, and restrictions on trading activity left these deals holding elevated volumes of triple-C-rated loans that the overcollateralization tests of a significant number of these deals was failing. And yet, loan prices were sufficiently high that calling the deal was in the money for the equity tranche investor.

Per Moody’s representative list, GoldenTree Loan Management called the largest volume of CLOs in the first half of 2024. The manager liquidated two transactions that were holding a par balance of $831.48 million: GoldenTree Loan Opportunities IX and X.

Benefit Street Partners called three CLOs (BSP CLO II, III and XI) which was the largest by deal count and the second most by volume, at $764.71 million. The next managers to call the most CLOs were Blackstone Credit ($657.62 million), MJX Asset Management ($485.77 million), Sculptor Capital Management ($465.08 million) and UBS Asset Management ($433.23 million).

UBS has called two transactions in 2024: Madison Park Funding XXVI, a deal the manager first priced in 2017, and Madison Park Funding XIII, which was a 2014 vintage transaction that reset in 2018. Reorg previously reported that the latter CLO was called and its portfolio liquidated via B-wic list on April 16.

The manager then priced a new issue, named Madison Park Funding LXIX, on the Friday of the same week. Madison Park LXIX’s portfolio contains many of the same names as Madison Park XIII, including Alterra Mountain Company’s term loan B, Amentum Government Services Holdings Term Loan B, and Project Boost Purchaser. According to Reorg’s data, the two CLO vehicles share 56 names in common which is an overlap of 17.6% weighted by the par balance of each loan.

That figure is fairly low for called deals in 2024. Irradiant Partners priced RAD CLO 24 on April 11, which has a portfolio overlap of 71.9% with the called transaction RAD CLO 1, with 302 loans in common between both portfolios.

MJX Asset Management’s April new issue Venture 49 CLO has an overlap of 38.5% with the called Venture 39 CLO, while Anchorage Capital Group’s April new issue deal named Anchorage Capital CLO 29, has an overlap with the liquidated Anchorage Capital CLO 4-R.

A stronger M&A pipeline that sources say is emerging for the final months of the year will begin to wean CLOs off their reliance on the secondary market and, with it, their reliance on the 85 to 100 price cohort. Meanwhile more bouts of volatility such as that seen in early August will create buying opportunities, and could dampen equity investors’ appetite for calling older vehicles in the months ahead. But the two categories of loans will continue to shape the performance of the H1 2024 vintage of CLOs over their life cycles.