After the CLO Rally, Selectivity Will Be Key as Fundamentals Shift

• Demand for CLO paper has been robust this year, and we expect it to remain strong through year-end given the rapid growth of CLO ETFs, moves by Norinchukin Bank in Japan to reallocate to CLOs, and continued demand from traditional CLO investors.

• Given strong demand, the average price of AAA to BBB rated CLOs is now above par and approaching five-year highs, with a corresponding decline in the spread basis between rating tiers, with AAAs and AA to BBB rated credits trading through their five-year medians.

• Signs of weaker fundamentals are appearing, with the number of deals with 5% or more Caa/CCC exposure rising materially since last year.

• With spread compression making it harder for investors to generate alpha and signs of weaker fundamentals emerging, we view a bottom-up approach that takes an informed view of the underlying CLO portfolio holdings as crucial to mitigating risks and generating better potential investment outcomes.

The CLO market has experienced a strong, broad-based rally since the fourth quarter of 2022, with prices rising dramatically and spreads tightening back to first quarter 2022 levels. The spread basis between ratings and manager tiers has also compressed, making it harder for investors to generate alpha. The technical backdrop may result in additional spread compression, or at least limit the potential for any significant spread widening in the short term. In an environment characterized by high valuations, with CLO tranches trading through fair value overall, we believe a bottom-up approach is best positioned to outperform over the longer term.

Forces driving increased appetite for CLOs

Demand for CLO paper has been robust this year, and we expect it to remain strong through year-end for several reasons.

In addition to the traditional investor base of insurers, banks, and money managers (among others) – which have been a consistent source of demand given CLOs’ strong performance since the Covid period – the CLO market has also benefited from the growing presence of CLO exchange-traded funds. The CLO ETF market has ballooned from approximately $2 billion at the start of 2023 to over $14 billion by the middle of this year, with over $8 billion of inflows thus far in 2024.1

While ETFs make up only 1%-2% of the total US CLO market, this incremental demand has been instrumental in driving spreads tighter, particularly at the AAA level, where much of the budding ETF market is focused. While we do not expect CLO ETFs to grow at the same rapid pace we saw earlier this year, we believe the market has room for significant further growth, spurring even stronger demand going forward.

In addition, Japan’s Norinchukin Bank, historically a big buyer of AAA rated CLO paper, recently announced a plan to reallocate JPY10 trillion (roughly $62.5 billion) of foreign government debt into corporate debt, a portion of which is expected to go to CLOs. Norinchukin’s change in allocation could spur similar moves by other Japanese banks, a buyer base that held JPY19.6 trillion ($122.6 billion) of CLOs at the end of last year.2 This reallocation could be a tailwind for further spread compression and ultimately additional CLO creation over the back half of the year and into early 2025.

If 25% of the JPY10 trillion ($63 billion) earmarked for reallocation is funneled toward CLOs, it would equate to roughly $16 billion of net new demand for AAA CLO paper.

AAA CLO demand

Sources: Norinchukin financial statements, Nikkei, and Bank of Japan, from Deutsche Bank’s “Chart of the Day - Japanese CLO AAA demand set to rise” as of 2 July 2024.

CLO prices are approaching five-year highs

Given strong demand, the average price of AAA to BBB rated CLOs is now above par, with prices for these portions of the capital stack in the 97th percentile or higher relative to prices over the past five years (see table). With the majority of CLO paper trading above par, the secondary market no longer offers the same amount of upside from potential price appreciation; and the redemption optionality for deals outside of their non-call periods leaves investors exposed to potential negative price returns.

CLO Prices Are Near Five-Year Highs Across Most of the Capital Stack

Source: JP Morgan CLOIE, as of 28 June 2024.

Over the past two years, the market has also seen a decline in the spread basis between rating tiers, with AAAs and AA to BBB rated credits trading through their five-year median. Investors lower in the capital stack will continue to benefit from higher coupon income, but that advantage is shrinking alongside the lack of additional price upside, resulting in a much less attractive risk/reward dynamic.

The Spread Basis Between Rating Tiers Has Tightened

Source: JP Morgan as of 30 June 2024.

The spread basis between top-, mid-, and bottom-tier managers has also decreased materially. Historically, top-tier issuers with higher levels of issuance and better deal performance were able to issue debt at tighter spreads, and therefore lower coupons, than smaller or new issuers with shorter or poorer track records. At the end of the second quarter, the difference in the average AAA spread between top- and bottom-tier managers was just 4 bps, down from 32 bps a year ago, with no difference between mid-tier and bottom-tier managers (see table).

Once the market experiences a selloff, we would expect these differentials to normalize, with higher-quality managers and stronger CLO portfolios outperforming as weaker profiles widen more drastically, highlighting the importance of a strong bottom-up selection process.

The Spread Between AAA CLO Manager Tiers Has Tightened Markedly

Spread change (bps) for BSL CLOs with five-year reinvestment periods

Source: Pitchbook | LCD, as of 25 June 2024. BSL: broadly syndicated loan. Top tier: 20 or more CLOs issued between 2011 and 2023; middle tier: between 10 and 19 CLOs issued between 2011 and 2023; bottom tier: fewer than 10 CLOs issued between 2011 and 2023.

CLO fundamentals have begun to soften

While prices have moved significantly higher, CLO fundamentals have shown signs of softening. One such metric is exposure to CCC rated holdings. We still believe the asset class remains robust and that CLO fundamentals are decent overall (see table), so we don’t view the fundamental backdrop as an immediate source of concern. However, any deterioration in the economic backdrop that results in an acceleration of loan downgrades could put additional stress on CLO portfolios that are close to or above the typical 7.5% CCC exposure threshold.

CLO Credit Quality Is Trending Down

Source: Kanerai, Intex, Barclays as of 30 June 2024. Data representative of US broadly syndicated loan (BSL) CLO 2.0 deal medians – both in and out of reinvestment.

Older-vintage CLOs that are now outside of their reinvestment periods are at even greater risk, as these deals, which already have weaker profiles, including higher Caa/CCC exposure, have more limitations on CLO management and loan purchases and therefore have fewer options available to make improvements (see table). In addition, the number of deals with Caa/CCC exposure has risen materially since last year, with S&P being particularly punitive (see chart). As a result, we believe a bottom-up approach in which an investor can take an informed view of the underlying CLO portfolio holdings is especially valuable, mitigating the risks associated with increasing CCC exposure and generating better investment outcomes.

Older-Vintage Deals Have Higher Caa/CCC Exposure

Source: Kanerai, Intex, Barclays as of 30 June 2024. Data representative of US broadly syndicated loan (BSL) CLO 2.0 deal medians – both in and out of reinvestment

While Median Moody’s Caa and S&P CCC Buckets Have Not Moved Too Dramatically Recently …

The Percentage of CLOs With Tight Caa Buckets (>5%) Has Risen Meaningfully

Source: Kanerai, Intex, Barclays. US BSL CLO 2.0 deal medians – both in and out of reinvest, as of 30 June 2024.

Despite expensive valuations and fundamental risks, valuations may remain elevated in the near term given the technical backdrop. New issuance rolled out at a record pace through the first half of the year, with $80.5 billion pricing through June and an additional $104.5 billion in refinancings and resets coming to market.3 However, much of this supply has been offset by an increase in paydowns and redemptions, resulting in a net CLO supply that isn’t as positive as might be expected, with the total size of the US broadly syndicated loan (BSL) CLO market increasing by just $8.3 billion so far this year.4

Through June, US CLO bond redemptions are estimated to be over $60 billion, roughly 6% of the total US CLO market, and could increase to about 14% by the end of the year if this pace holds (see chart). These supply dynamics alongside strong demand have pushed prices higher and spreads tighter.

CLO Bond Redemptions Have Shot Up in 2024

Source: Intex, Deutsche Bank Research, as of 30 June 2024.

Notwithstanding the shorter-term technical tailwinds, we believe expensive valuations and a fundamental picture bifurcated between vintages and, relatedly, between deals in and out of their reinvestment periods, calls for a robust bottom-up approach to security selection for long-term investors. While CLO investors across the spectrum have benefited over the past 18 to 24 months, the rally won’t last forever, and we believe investors would be well served to be more selective about the CLO portfolios and managers they choose.

As an investor in third-party CLOs, for us this means seeking managers with extensive experience and a track record of successful deal execution and superior risk management. This begins with careful loan selection to create a strong collateral base, along with the trading skill to take gains, avoid losses, and adjust the portfolio as market conditions evolve. Sound risk management is both a cause and effect of these best practices and is reflected in the results.

Ultimately, we believe a more selective, bottom-up approach will result in stronger risk-adjusted returns and outperformance potential over the broader market and peers in the long run.