CJ Doherty: Welcome to the Lending Lowdown. I'm CJ Doherty, Director of Analysis at LSEG LPC, and I'm delighted to be joined today by my colleague Kristen Haunss, who is assistant editor covering the US loan and CLO markets. We're excited to bring you our 15th podcast in the series. So thank you, everybody, for tuning in. Today we're going to talk about US CLOs, the biggest buyers of leveraged loans, and we'll discuss the most pertinent trends in the market currently. Kristen, thanks for joining me today.
Kristen Haunss: Thanks for having me, CJ. I'm excited to be here.
CJ Doherty: So, Kristen, it's been a down year for CLO issuance. If we look at some of the most recent numbers, us. CLO new issued volume amounted to roughly 21 billion in the second quarter, and that was actually the lowest quarterly level since the first quarter of 2020 at the onset of the pandemic. And then if we look at things from a semiannual perspective, the first half of this year issuance was at about 55 billion, and that was down 24% from the same point last year. So, Kristen, given the downward trend I just mentioned, let's kick off our chat by talking about the drivers of this drop in CLO activity.
Kristen Haunss: Yeah, the biggest challenge to CLO new issuance has definitely been the arbitrage and what that means for lower equity returns. Liability costs have gone up, partially due to an increase in SOFR, but also due to higher AAA spreads. Discount margins on new deals were about 194 basis points last month. And while this is down from late last year, it's still quite a bit higher than the 130 to 140 range that we saw in the first quarter of 2022.
CJ Doherty: Right. And I think another visible trend in the CLO market is that pricing dispersion in tiering is very pronounced. You know, new issue AAA spreads, I believe, range from roughly 170 to around 230 basis points in the last month and a half. And there is a hope that some tier one managers may be able to break into the high 160s soon. But tier two managers are still coming in around the 220 or higher mark.
Kristen Haunss: Yeah, while spreads are still wide, there's definitely some optimism that we could see some tightening. JP Morgan last week actually lowered its AAA four cast for tier one issuers and it's dropped it now to that 160 basis point range. But the largest US banks still aren't buying in size like they used to and this is allowing the buyers that are still in the market to keep prices at these wide levels.
CJ Doherty: Okay, so let's talk a bit about other challenges too. Apart from the arb, which you mentioned, Kristen, co managers face a lack of new loans coming to market. There have been fewer loans issued as M and A activity has slowed dramatically in the last 18 months or so.
Kristen Haunss: Yeah, also important to note that loan prices have improved quite a bit. So the secondary is just less attractive than it was a few months ago.
CJ Doherty: Yeah, absolutely. But just to talk a bit more about loan supply first, the lack of new deal flow has made CLO creation relatively more difficult. New money institutional loan volume reached only 12 billion in the second quarter and this represented a decline of 74% year over year as the M and A market really has struggled to gain traction amid a disconnect between buyers and sellers around valuation, not to mention higher borrowing costs. But on a more positive note going forward, lenders say M and A chatter picked up during the most recent quarter. Some say that early stage preparations for auctions among leverage credits saw an uptick. That said, on the other hand, the reality is that in the current environment, deals are taking longer to get done and require far more planning.
Kristen Haunss: Yeah, definitely. And just going back to the loan prices, prices in the secondary have gone up quite a bit, as we had mentioned, and they're actually now at the highest level since May 2022. And these higher prices mean CLO managers just have fewer options to pick up loans cheaply in the secondary market. It right now about 60% of loans are trading above $0.98 on the dollar.
CJ Doherty: Right. And this backdrop really has made higher equity returns more difficult to achieve. In turn, managers are having to bring their own equity to get deals done, as third party equity is not readily available given the arb situation.
Kristen Haunss: Yeah, and equity returns are not the only area being affected by these widespreads the. Wider AAAs are also making refinancings and resets more difficult. So some deals that are now coming off their two year non call period when they priced were at as tight as 100 basis points. So quite a bit tighter than the current AAA market.
CJ Doherty: Okay, and so what do you think this means for Issuance for the rest of the year?
Kristen Haunss: Yeah, good question. So Morgan Stanley actually lowered its combined refi and reset forecast to 5 billion. JPMorgan is a bit more optimistic and said it expects refinancings and resets to pick up marginally this year. And the bank put volume at about 15 billion by the end of the year. So while activity has been slow, we have seen a few resets recently, including deals with one year non call periods. So there could be more of these shorter dated CLOs that look to come back to the market to reset.
CJ Doherty: Okay, I also want to touch on another topic of discussion in the CLO and indeed the loans market these days, and that's deals coming out of their reinvestment period and the impact on the loan market. And just to put some numbers on it, almost 25% of funds, that's about 235,000,000,000, are outside the reinvestment period right now. And this number is really expected to grow with close to another 115,000,000,000 scheduled to exit period by the end of the year. So, kind of the knock on effect or related to this, the limitation on CLOs being able to buy a longer dated debt is impacting borrower plans and ability to extend maturities. And I think this is particularly relevant these days as amend and extends are expected to be a big part of the loan calendar going forward.
Kristen Haunss: Yeah, definitely. And I think speaking of loans, it's important to note many managers are focused on credit quality right now, especially because borrowers have been challenged by rising rates, inflation, recession, fears. And while there's not been a big pickup in defaults, there has been some deterioration downgrades outpaced upgrades this year, and more than 10% of loans in the market have been downgraded in 2023.
CJ Doherty: Right. And if we look at the wider institutional loan market, the default rate ended June at pretty close to 3%. I think it was 2.9% according to Fitch, so still not too high. But the default rate is still forecast to climb to the four to four and a half area by year end. And just moving on from credit quality before we wrap up, Kristen, can you talk a bit about the outlook for the rest of the year? Right now, we're just past the halfway mark. Issuance is at roughly 59 billion, so nearly 60 billion. And I think the expectation is that there'll be a similar pace of deal flow in the second half of the year as we saw in the first six months of 2023.
Kristen Haunss: Yeah, that's right, CJ. Just to put those numbers into perspective, there was about 73 billion of US CLOs raised in the first half of last year, and the market finished up with about $129,000,000,000 of volume. So for this year, Morgan Stanley is calling for 100 billion in total US. CLO new Issuance, and JP Morgan actually just revised its forecast and is now also calling for 100 billion. So it could still be a relatively strong year even if volume is down from 2022.
CJ Doherty: Okay, so much to keep an eye on in the market as the year progresses, and that's all we have time for today. Thanks for joining me, Kristen. Hopefully we can do it again in future.
Kristen Haunss: Thanks, CJ. This was great.
CJ Doherty: And thank you all for tuning in. I invite you to check out our CLO news and analysis loanconnector.com. Follow us on Twitter at LPC loans. I'm CJ Doherty. Subscribe to the Lending Lowdown on your favorite podcast platform.
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