The list of factors likely to impact the collateralized loan obligation (CLO) market just keeps growing. In addition to record inflation, more aggressive rate hikes, and the floating-rate debt market’s transition to the secured overnight financing rate (SOFR) by July 2003, Russia’s invasion of Ukraine brings a whole new level of risk and uncertainty to the financial markets.
Michael Kurinets, chief investment officer and portfolio manager since 2013 at Capra Ibex Advisors, an investment and risk advisor to high-profile names including First Republic Bank and J.P. Morgan, spoke to Asset Securitization Report about how today’s changing dynamics could impact CLOs. Previously heading up Credit Suisse’s secondary trading desk for CLOs and collateralized debt obligations (CDOs), Kurinets sees a CLO market facing volatility that potentially presents both plusses and minuses for the CLO-equity investments that Capra Ibex specializes in.
ASR: As we head into 2022, what do you see driving the CLO market?
Kurinets: For the bulk of last year, what really drove credit spreads, whether high-yield or investment-grade, was the market’s response to COVID. President Biden promised 100 million doses in the first hundred days of last year, stimulus packages, then finding out not everybody was taking the vaccines, then variants of the virus came. The driver has since moved from the health care space and into the financial space, which we understand better.
ASR: Can you expand on that idea?
Kurinets: Starting in April 2020 there was substantial easing of interest rates, which fell [to] close to zero by the middle of May 2020. But now, in response to rapidly rising inflation, we are in a rising rate environment and seeing a reversal of quantitative easing. Money is being pulled out of the system and it’s difficult to predict the Fed’s rate hikes—last October people were debating whether the hikes would start in second half 2022 or in 2023, and now they’re saying as many as seven this year. That creates market volatility.
The transition away from the Libor benchmark to SOFR has been another factor. CLO activity started becoming elevated last August, as the year-end deadline for pricing new deals over Libor approached, and people pulled forward deals slated for 2022 into 2021.
ASR: How has the war between Russia and Ukraine impacted volatility and the loan market?
Kurinets: I see the U.S. economy as relatively insulated from the horrific shocks happening in Eastern Europe. There may be an indirect effect because of energy prices affecting Western Europe, which is the U.S.’s biggest trading partner, but any resulting volatility should be short term, whether a week or three months. The weather is warming up, and there are other ways to supply Europe with oil and gas by next winter. We’ll probably see elevated prices at the gas pump, but this is very far from the country entering a prolonged recession and companies default on debt.
ASR: How will that volatility impact CLOs?
Kurinets: Volatility benefits existing CLO equity that has a significant reinvestment period remaining, because the liability costs are locked in but CLO managers are able to buy high-quality loans at lower prices. Long-term equity is designed to benefit from these types of situations and performance shouldn’t suffer.
It’s not good for CLO equity that’s out or soon out of the reinvestment period, because those deals become staticky and are priced largely on their liquidation values. They won’t perform well because CLO equity is roughly leveraged by 10 times, so for every point the loan market sells off, CLO equity falls by 10 points.
ASR: So investors will shy away from CLO equity with shorter reinvestment periods?
Kurinets: Yes, it becomes more difficult. For example, there was a recent bid list for equity in four different CLOs, all of them shorter, and none of them traded. The bids are four or five points lower than they were a month ago, and the buy-side account decided not to sell.
We’re picking and choosing, because our view is that we may have near-term volatility driven by this awful war news, which likely will get a lot worse.
ASR: Will volatility impact the new-issue CLO market?
Kurinets: New-issue volume should definitely decrease, for a couple of reasons. Once managers have enough assets in a warehouse, dealers figure out pricing on the AAA tranche and the equity, before pricing the tranches in between. But in a period of volatility the pricing on the AAA tranche moves around and it’s harder to get investors to come in for big-ticket purchases.
In addition, only a small percentage of CLO managers have captive funds for CLO equity, and those deals will get done. But most need third-party investors to buy the CLO equity, and third-party equity responds immediately to what happens in the market and may require some pricing gymnastics. So the new-issue market becomes much more difficult.
ASR: How will that impact CLOs transition to SOFR?
Kurinets: All new loans must be priced over SOFR. But as we track them, SOFR loans are de minimis, making up approximately 2% of the outstanding market. Legacy CLO liabilities priced over Libor flip to SOFR typically when 50% of assets are priced over SOFR, and that looks pretty far away. But I think CLOs will eventually reach that trigger from refinancings of existing loans already in the transactions.
ASR: What is your outlook for refinancings?
Kurinets: During periods of elevated volatility, refinancings of both CLOs and leveraged loans are likely to slow because credit spreads will widen. The market now sees the basis spread between three-month SOFR and three-month Libor at about 17 basis points, which is lower than the 26 basis point fallback spread written into contracts for when Libor is no longer representative and Libor loans must transition to SOFR loans. So no loan issuer is going to voluntarily transition before then.
Issuers might say I’ll refinance my loan to SOFR if my overall cost to borrow doesn’t rise, but there are legal and other costs to refinance, so that’s much more likely to happen in a period of lower volatility—when the Libor to SOFR basis spread is likely to be lower. If the three-month Libor-to-SOFR basis spread falls inside 10 basis points, I would imagine a lot of issuers will want to reset their loans.
ASR: Will inflation impact CLOs?
Kurinets: Unless inflation translates into a recession and loan defaults, it’s pretty much irrelevant for CLO debt tranches because they’re floating rate.
When inflation leads to higher rates, CLO equity begins to lose benefits of Libor floors. However, as rates continue to rise above the strike on Libor floors, which are typically between 50 and 100 basis points, cashflows to CLO equity begin to rise again. [That’s] because 100% of CLO collateral is floating-rate loans while only 90% of CLOs’ capital structure is liabilities. Therefore, the cash flows from the remaining 10% of collateral goes to CLO equity.
ASR: So should there be seven rate hikes, CLO equity will benefit?
Kurinets: Whether we get to that level is unclear, since the higher commodity prices today may slow the economy and dampen inflation, and we don’t know how the Federal Reserve will respond. But if Libor or SOFR increase to 3% or higher, CLO equity will undoubtedly see higher cash flows.
