CLO Active Credit Lines Near 200, Paving Way for Market Rebound

(Bloomberg) -- Banks stand ready to lend billions of dollars to money managers to buy leveraged loans to be packaged into collateralized loan obligations when markets calm and slumping sales rebound.

There may be close to 200 active lines of credit, or warehouse lines, financing CLOs now, John Clements, head of the U.S. CLO business at Barclays Plc, said in an interview. This is roughly on par with the record number of warehouses opened last fall, which telegraphed what turned out to be an all-time high for CLO sales in 2021.

Volatility spurred by Federal Reserve efforts to tame inflation and Russia’s war in Ukraine have hampered CLO sales with issuance running more than 20% lower compared to the same period last year. High CLO spreads and volatility in loan prices make it difficult to predict the profitability of creating a CLO, which dictates whether a deal moves forward.

“Since there are so many warehouses out there which are available and in place, we think we can see some pretty healthy CLO new issuance over the course of the year,” Gretchen Bergstresser, a partner at CVC Credit, said in an interview. 

“Pricing on CLO AAAs is too dislocated,” meaning that risk premiums are still too wide, JPMorgan Chase & Co. strategists led by Rishad Ahluwalia said in a Thursday research note.

This leaves the established warehouses -- some set up months ago, some more recently -- in limbo, stalled for the time being and at the mercy of the price swings on both the CLOs and the underlying collateral.

While the large number of warehouses bodes well for the return of strong issuance later this year, it may not happen anytime soon, observers say. The market needs to see more investors in CLO AAAs come back in as buyers in order to help drive demand, Bergstresser said.

“What’s ironic is that some of those warehouses are better off if they’re less ramped up,” or in the earlier stages of establishing the final loan collateral for the CLO, Barclays’ Clements said, because loan prices had sunk earlier in the month, and lower prices on the collateral is good for the arbitrage. “During a widening market, those will have a better chance of getting done because you can buy collateral cheaper.”

Equilibrium

Wall Street banks are among the biggest providers of CLO warehouses, which are the financing vehicles CLO firms use to buy and store loans before packaging them into bonds.

The profitability of assembling a CLO -- or whether it makes sense to do one -- is called the arbitrage, or the gap between the interest earned from the underlying leveraged loans and the cost of borrowing to purchase the assets. A healthier arbitrage enhances the economics of the transactions, which makes it easier to attract CLO equity capital to sponsor new deals.

Arbitrage is most attractive when loan prices are low and CLO AAA risk premiums are tight.

Currently, risk premiums on CLO liabilities, particularly AAA slices, remain stubbornly wide. Loan prices have been volatile at best -- soaring to 15-year highs in January, sinking to 15-month lows by mid March, and rebounding slightly over the last five days. 

“If you went out and bought all the assets for your CLO today, it would be tough to create an attractive arbitrage,” Bergstresser said, noting that the rise in loan prices in recent days didn’t help. “Absent further downward pressure on loan prices, we need to still see some tightening on CLO liability spreads for the CLO machine to really start up again.”

The arbitrage has been shrinking for most of this year, mainly inhibited by wider AAA CLO spreads. But lower loan prices earlier this month offset it and as a result, at least nine CLOs were quickly completed in the market in just a few days in early March, as some managers took advantage of the cheaper collateral, Bergstresser said. But with a rise in loan prices in recent days, that window may have closed.

In the meantime, the fate of the warehouses -- and whether their loans are under water -- differs from manager to manager and depends on a variety of factors, including when the loans were assembled, how much of the deal is already ramped up, whether the manager has secured equity investors or AAA buyers, and whether the manager is willing to increase the size of the deal once loan prices have gone down again, Bergstresser said.

There are many different levers they can use to move a deal forward, she added.

Relative Value: CMBS

• Despite notable cheapening in CMBS AAAs versus lower-rated paper over the past two months, AAA SASB floaters, AAA CRE CLOs, and last-cash-flow AAA bonds offer considerable value and are well positioned to benefit from narrower spreads over the near term, especially in light of their recent underperformance vis-à-vis bonds at the bottom of the cap stack, Bank of America strategists said in their weekly securitization research report
• These selections can be a type of “defensive positioning” amid continued uncertainty in Eastern Europe, evolving inflation expectations, and the potential that the U.S. could be entering into recessionary waters over the next year, the strategists sad
• Despite some spread widening, single-A corporate financial paper currently offers a significant pickup versus LCF AAA CMBS conduit bonds

Quotable

“While the mortgage refi indices are currently sitting at their lowest level since June 2019 (away from some year-end noise in 2020), they remain well above levels seen in 2018 when the Fed was hiking interest rates,” said Scott Buchta, head of fixed income strategy at Brean Capital. “At this point in time, less than 20% of the conventional universe was refinanceable vs. 5% today. The big difference between the two periods has been home price appreciation, and cash-out refis remain a big driver of refinancing activity as a whole (still 44% of all loan applications).”

What’s Next?

ABS deals in the queue for next week include Freedom Financial (consumer loan), Upstart (consumer loan) and Veros (subprime auto)

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