Last year, collateralized loan obligation (CLO) issuance plummeted and spreads ballooned at the start of the coronavirus crisis as new deals came to a halt in March.
But the CLO market proved resilient, rebounding in the second half of the year to prompt an upbeat outlook for managers and investors heading into 2021.
Although returns may be lower than in recent years, CLO securities (particularly the senior-rated tranches) remain very attractive compared to alternative investments.
“These deals have proved to be resilient, especially the senior and mezzanine tranches,” said Shan Lai, a vice president and senior analyst at Moody’s Investors Service, during a panel discussion at the virtual ABS East industry conference in early December.
“If you look at traditional optimization or asset-allocation models, CLOs seem very cheap compared to most [similarly rated] asset classes,” said John Kerschner, head of U.S. securitized products at Janus Henderson Investors, in an interview withAsset Securitization Report. “With AAAs at 130 basis points, there really aren’t other [AAA investments] that you can buy at those types of spreads.”
“We remain optimistic on the CLO sector,” added Pratik Gupta, head of CLO research at Bank of America, “because we see a [ratings] upgrade story with a lot of room to go.”
Many market participants believe in the 2021 upside stemming from the CLO market’s second-half recovery last year, due to the resiliency the asset class showed in the midst of the economic pressures from the coronavirus outbreak.
“I think COVID presented a very intense stress test, which in general CLOs have passed convincingly despite a lot of negative publicity over the last couple of years,” said Ryan Suda, a partner at law firm Mayer Brown, also during the ABS East conference hosted in December by the Information Management Network (IMN).
Plenty of risks remain, for sure, as the COVID-19 pandemic continues, and sources acknowledged the unexpected could dramatically alter their rosy outlooks. But as Bank of America noted in its 2021 CLO outlook report, the rapid development of vaccines has significantly improved economic prospects, and the default rate for underlying leveraged loan assets are unlikely to increase – and may actually decrease to 3.5%.
That has led to projections of new issuance volume totaling between $80 billion to $110 billion for 2021, a mar well ahead of the hampered 2020 output but behind the 2019 volume of $118 billion and the record $127 billion in 2018.
The estimated 2020 year-end new-deal volume of approximately $91 billion, according to JPMorgan high-yield and leveraged-loan research, was limited from pandemic-related economic limits, but had rallied for a $15.5 billion issuance month for new, non-refinance volume in December.
What didn’t rebound toward the end of the year was refinancing and reset activity, as widening spreads made for unfavorable market conditions for managers. According to research from Deutsche, there was just $17 billion in refi activity and $10 billion worth of reset deals
But next year is expected to be a boom for refinancing and resets of existing deals, mostly due to the expiration of an avalanche of non-call periods mostly built up from 2020 deals issued with shortened shelf lives. Bank of America projects $30 billion in refinancings and the same volume of resets in 2021.
“You could own some discounted bonds in a deal that gets reset, so you could be pleasantly surprised next summer when your bonds get taken out at par,” said Neil Desai, managing director at Whitestar Asset Management.
John Kerschner, head of U.S. securitized products at Janus Henderson Investors, noted that prices of CLO tranches across the ratings stack plunged in the “dark days of March,” with secondary market AAA bond prices falling in some cases to the high 80s, and they have since all but recovered.
Similarly, BBB-rated CLO spreads now hover around 350 basis points, compared to below 200 basis points on BBB-rated corporate bonds, Kerschner said. He added that Wall Street’s forecast of a 2021 default rate between 3% and 5%—not much higher than normal—and the likelihood of more leveraged loan upgrades suggests further spread tightening.
“It’s hard not to be bullish unless you have a drastically pessimistic view” on the economy and pandemic, Kerschner said.
CLO bonds’ lagging if still impressive recoveries compared to alternatives such as corporates may offer opportunities in the secondary market. Neil Desai, managing director at Whitestar Asset Management, noted that CLO refinancings and resets, when a transaction’s duration is extended, were relatively few in 2020, in the $30 billion range.
He added that volume will ramp up 2021, when numerous deals’ non-call periods end.
In the primary market, spreads also widened dramatically, with pre-COVID spreads on AAA bonds hovering around 100 basis points, then jumping by 400 basis points or more in late March and early April. They quickly returned to around 200 basis points in May and have largely returned to pre-pandemic levels.
Bank of America foresees AAA bonds rallying another 10 basis points in the near-to medium-term. Kerschner said he anticipates more CLO spread tightening early in the year, followed by spreads remaining range bound.
“We look at 2021 as more of a year for carry, with much lower volatility and a slowly healing economy,” he said.
Nevertheless, CLO bonds’ relatively attractive spreads and prices, compared to similarly rated alternatives, can be “highly advantageous,” Kerschner said, and Janus Henderson expects CLO spreads to be attractive to alternatives for at least another year, and potentially longer.
“Bottom line, many investors have low to zero exposures to this nearly $1 trillion asset class, and it will take some time for allocations to increase and CLO spreads to normalize,” he said.
