The leveraged loan market remains largely bereft of new transactions, requiring CLO managers to rely on the secondary market to issue new deals and meet investor demand, which remains strong despite uncertainty about what lies ahead for the economy.
Benefit Street manages a total of $75 billion in assets split into six strategies: Private debt/opportunistic credit, CLOs, high yield, special situations, structured credit and commercial real estate. Daniel Ryan, managing director and co-head of Benefit Street's CLO business, recently spoke to Asset Securitization Report about issues facing CLO assets and liabilities and where risks lie.
ASR:New leveraged loan issuance in Q1 totaled $15 billion compared to $163 for all of 2022, requiring new CLOs to rely largely on secondary market debt. How has that impacted CLO managers?
Daniel Ryan: The market has really become what folks are calling "print and sprint," where managers are buying most assets in the secondary market as quickly as possible to lock in the arbitrage, minimizing the warehouse risk. It's a tricky balance to strike, however, because today's loan prices are volatile. CLOs typically seek to lock in the AAA liability price a couple of weeks before finalizing pricing on the whole deal, so they are at risk of loan prices moving significantly during that window.
ASR:Is relying on the secondary market for assets sustainable?
Ryan: I think there's enough liquidity to continue at the current pace for CLO issuance. The CLO market issued $34 billion in the first quarter, which is on pace to be the second highest year ever, only behind 2021. There has been $11 billion in outflows from retail mutual and ETF loan funds, and there are cross-over accounts rotating between high-yield and loans where they see opportunities on a relative basis. So, there's been enough paper leaving those markets to allow for new CLO issuance.
ASR:Why are retail investors leaving floating-rate loan funds when rates may go higher?
Ryan: Historically, as 10-year Treasury yields have increased, retail money has flowed into the loan asset class. I think the best explanation for the decoupling of that relationship is that the Fed is engineering tighter financial conditions, leading to an economic slowdown and potentially a recession, which would negatively impact leveraged credit. Other credit products like investment-grade credit also look attractive on a yield basis relative to recent history. That's left a great buying opportunity for CLOs with dry powder. The leverage-loan index price is now around 93.5 while over the last decade it's been above 95 around 75% of the time, and above 97.5 nearly half the time. To have that upside potential on loans is a rare opportunity and represents a potentially great investment over time.
ASR: The price for leveraged loans has lingered in the low 90s since last fall. How long might that last for?
Ryan: I think it's lasted this long because there is fear, particularly for B and CCC credits, that there's going to be a downgrade cycle from the rating agencies. In addition, the combination of higher rates and a macroeconomic slowdown may lead to increased defaults. I think the market will remain range-bound for the next three to six months. We need to see more macro evidence of either a soft or hard landing. Will inflation slow and allow the Fed to end its tightening, likely resulting in a soft landing? Or will inflation prove stickier, leading to further tightening, increased unemployment, and a hard landing? The leveraged-loan price has bounced between 92 and 94 over the last six months, and every time the index has moved above 94 it has faced resistance.
ASR: So given continued uncertainty, could that discount last for a while?
Ryan: The downgrade rate was slower in January and February than people expected, and it started to increase in March, with 4Q 2022 numbers the likely catalyst. More macro data will clarify if there will be a soft or hard landing, and whether the rating agencies take additional actions this summer. So it could stay range bound for the next couple of quarters.
ASR: What is the riskiest scenario from a CLO perspective?
Ryan: If you're an investor in BB or BBB bonds, what keeps you up at night is probably defaults. Right now, CCC-rated loans are at a pretty healthy level, and if it does get to 10% or more—where it was during Covid —there's enough overcollateralization cushion for the preponderance of deals to withstand that. The longer-term impact of realized par destruction through defaults is the much bigger concern than just CCC levels being high. CCC levels come and go with the rating agencies' views on the broader economy, but realized losses through defaults is the biggest fear for BB and BBB investors, and certainly also equity.
ASR: How should investors be viewing CLOs compared to alternatives?
Ryan: It varies across the stack. For AAA bonds, it's largely a pricing exercise relative to other fixed-income products, so it's more about whether they're buying this AAA CLO at an attractive level or not. For BB and BBB investors, the question is the relative value of new issue bonds versus those in the secondary market. There have been periods when we hear from investors that they can buy a shorter duration BB with a greater discount and a relatively healthy portfolio in the secondary market compared to a new deal. So when secondary mezzanine trades offer those opportunities, it makes pricing mezzanine for your new issue CLO tougher because you can't offer as much dollar discount from a pricing perspective.
ASR: Where are you seeing opportunities, given that pricing dynamic?
Ryan: Short duration, high quality loans are in high demand, because many CLOs are exiting their reinvestment periods and that limits the names they can buy to shorter duration transactions. Given where coupons are, with mid-to-high, single-digit yields, BB loans are perceived as low risk and interesting to investors outside the CLO universe, especially banks. They're willing to pay prices that are slightly above par, because they're less sensitive to losing a bit on the P&L. I think the market will continue to view those types of assets as good opportunities and remain well bid. There is much more price dispersion for [credits rated B-] right now and I believe managers have opportunities to add value swapping in those.
ASR: Given the uncertain times, what are the macro risks Benefit Street Partners is looking out for?
Ryan: A big one is how long rates will stay at this elevated level. Right now, the market is pricing in cuts faster than the Fed is indicating, so there's a disconnect. The last obviously positive macro data point continues to be the jobs data; if we start to see unemployment rising while inflation remains sticky, that would be a recipe for a hard landing scenario.
