Bank of America is perpetually among the top banks leading collateralized loan obligation (CLO) offerings as well as syndicating the leveraged loans that CLOs purchase, giving it keen insight into those markets. Depressed leveraged-loan originations that feed new CLO issuance continue, while investor demand for CLOs has fueled record issuance, squeezing CLO equity investors' arbitrage. And CLO managers and their investors are working through Libor-transition issues as the June 30 deadline for the floating-rate transactions to transition to a new benchmark quickly approaches.
Pratik Gupta, who heads up RMBS and CLO research at BofA, recently spoke to Asset Securitization Report(ASR) about the bank's outlook for the leveraged lending and CLO markets and where it sees the challenges and rewards for CLO-market participants.
ASR: What is Bank of America's outlook for the U.S. leveraged loan market?
Gupta: We think defaults are going to increase over the near-term that will crystalize in wider pricing for the loan market, especially when it comes to 'CCC'-rated debt that will likely see an increase in downgrades in the near-term. This points to wider CLO spreads.
We are also calling for a soft landing, and when indications of that are clearer we think the market will rally. We're also projecting that agency MBS spreads will tighten toward year-end, and that will drag other sectors tighter as well.
As defaults pick up, there are lender-on-lender lawsuits and asset stripping in the loan market—these shenanigans have resulted in lower recovery rates for many borrowers.
ASR: Have any of those projections changed since the start of the year?
Gupta: No, that's always been our call. We projected Q1-end spreads to be tighter, and that's what happened. We think Q2 spreads will be wider from where they are today, and Q4 spreads slightly tighter from where we end up in Q2.
Our original trade for mezzanine bondholders was to buy 30-year Treasuries and 'BB' CLOs, and for money managers focusing on cleaner quality loans we highlighted 30-year Treasuries and 'AA' CLOs. The top performing asset classes to date have been exactly that, with Treasuries returning 6% and 'BB's returning 7%. That trade will continue to work well for two reasons: If there's a hard landing, Treasuries will rally, mitigating any 'BB' downside; and if rates remain higher for longer, the 'BB' CLO carry is attractive.
ASR: What are the biggest challenges for CLOs?
Gupta: From an investors standpoint, we think it's going to be calibrating the recovery rate. With defaults so far this year, the loan recovery rates have been low, close to $0.20 [on the dollar] versus the historical $0.65 to $0.70.
As defaults pick up, there are lender-on-lender lawsuits and asset stripping in the loan market—these shenanigans have resulted in lower recovery rates for many borrowers. When one group of lenders extracts a higher recovery rate at the expense of another group of lenders, recovery rates range from as low as $0.30 and to as high as the historical average. Investors need to understand what their managers are doing to mitigate defaults, and if they experience defaults do they have the expertise to extract the higher recover rate? It's going to be a challenging market.
ASR: What role do "cov-light" loans play in today's CLO market?
Gupta: Cov-light has meant lenders don't have a seat at the table when things for borrowers go badly, and that's been a problem since the Great Financial Crisis (GFC). It drove recovery rates lower, from the historical 85% to today's 65% to 70%. Asset stripping and "up-tier priming" is a more recent phenomenon, post COVID, that has caused recovery rates to dip.
ASR: How widespread is it?
Gupta: The small number of defaults so far has put a focus on the companies that did it. It's an adversely selective cohort, as opposed to being widespread. Lenders know this is happening and they're trying to make sure they're protected, since there's a risk it could become widespread.
ASR: Has the bank-funding crisis fueled by the banking crisis in March had an impact?
Gupta: There is a credit squeeze happening, and that means it is going to be tough for loan issuance to pick up. Private credit has been a risk mitigant, providing a substitute for bank credit, and that's a positive thing because borrowers know there are liquidity providers out there.
Third-party equity investors are not looking at the primary CLO market now and are seeing opportunity in the secondary market and especially CLO mezzanine.
ASR: Has the availability of private credit made it easier for leveraged companies to get loans?
Gupta: The last half of 2022 was very challenging, and so was Q1 of this year. Ironically Q2 has seen some pickup in the broadly syndicated loans (BSLs). That will help CLOs because, excluding refinancings, loan issuance is at one of the lowest volumes since the GFC.
ASR: And yet CLO issuance is near a record year to date, at $44 billion …
Gupta: Not enough new loans are being created, so demand for high-quality loans has only gone up. That has reduced CLO arbitrage, to the point [where] it no longer works for many equity investors.
ASR: Can CLOs rely on banks' loan warehouses to sustain volumes, or must they resort to the secondary market?
Gupta: There are still a lot of loans outstanding across warehouses right now, probably upwards of $23 billion. So far this year, the CLO new issue machine is still functioning well.
ASR: How are managers dealing with unattractive arbitrage?
Gupta: What is driving most of the deals is managers investing in their own equity, rather than third-party equity investors. Once spreads tighten, they can refinance their debt and the lower cost of financing will improve their arbitrage.
It's beneficial for CLO managers to invest in their own equity because they also earn a management fee. So the threshold of viable equity returns is probably lower for a CLO manager than a third-party provider. Third-party equity investors are not looking at the primary CLO market now and are seeing opportunity in the secondary market and especially CLO mezzanine, where they can get double-digit returns.
ASR: How is the market treating CLO bond investors?
Gupta: The story for 2022 and 2023 is that CLOs have been the best asset class to own and to sell. When investors have wanted to raise cash, they've generally sold the highest priced assets first, and that's typically been CLOs. That's one reason I think the CLO investor base in this market has grown. CLOs have a been a good asset to own because of their total returns, and given their floating-rate nature they've held up very well versus fixed-rate assets.
ASR: Are there any lingering Libor-transition issues?
Gupta: On the loan side, about 30% to 35% of loans are now referencing SOFR, and there's been a lot of variance in the credit spread adjustment (CSA) [that makes up the difference between the two rates when loans transition from Libor to SOFR]. On the liability side, a handful of bonds have already transitioned to SOFR and most will transition on the June 30 deadline or after.
Most investors expect CLO managers to transition to term SOFR plus 26 basis points (the Alternative Reference Rates Committee's recommended CSA), and I don't think there will be a lot of variance there. The variance may be on the loan side, and that could be an issue for equity investors, since they will bear that cost.
ASR: Have banks returned to investing in CLO 'AAA' bonds, after shying away in 2022?
Gupta: We're seeing Asian banks come back to the market. But despite U.S. banks not being very active last year, we still saw the second highest volume of CLO issuance. We think it's a testament to the domestic investor base expanding and including more money managers and insurance companies.
