By Mike Kurinets, Chief Investment Officer
Key Takeaways:
Regional bank crisis drove market volatility in March. The unexpected news that Silicon Valley Bank (SVB) and Signature Bank entered FDIC receivership sent all markets, including the leveraged loan market, into turmoil.
Leveraged loan prices dropped during the height of the banking crisis, but recovered some losses towards the end of the month. At March’s lows, leveraged loan prices had fallen 1.6 points, but the market recovered somewhat to end the month just 0.9 points lower than in February.
CLO liabilities widened significantly intra-month, but regained much of that ground by the end of March. The middle of March saw CLO liabilities 40 to 50 basis points wider across the capital structure. Most of that widening reversed by the end of March, and CLO liabilities ended the month less than 10 basis points wider than they started the month.
Hedge funds pulled the plug on CLO warehouses. Some hedge funds, which had been first loss providers to CLO warehouses, decided that it was not worth waiting for the warehouses to be repackaged into CLOs and instead liquidated those warehouses.
Though inflationary measures remained high, they were lower than in February. In March, YoY CPI data came in at 6% while MoM was 0.4%. While both numbers are below those reported in February, the Chairman of the Federal Reserve indicated that more rate hikes remain likely. Later in March, the Fed raised rates by 25 basis points [1].
CLO equity prices fell in March. Trading volumes in CLO equity essentially disappeared in March, and several Bid Lists were either indefinitely postponed or failed to trade. However, the limited color we’ve seen suggests that CLO equity prices declined in March.
Banking Crisis Sparks Market Turmoil
Immediately after SVB and Signature Bank suddenly entered FDIC receivership, the markets panicked. A number of questions circulated around the investment community: Would uninsured depositors lose money? Which other regional banks would fail? How would the availability of credit change? Would a hard landing become unavoidable? Would this panic signal a repeat of the 2008 Global Financial Crisis?
To understand how the markets responded to the banking crisis, it is important to understand how the crisis started. Regulation in the wake of the 2008 crisis lowered banks’ leverage and limited the types of assets that banks could hold. Shifting away from the risky products that had been impaired in 2008, banks held mostly low-risk assets such as (1) loans they originated, (2) US treasuries, (3) US agencies, and (4) highly rated municipal bonds. However, the 2008 regulations did not directly address the mismatch between the low duration of bank deposits -- which can be withdrawn intraday -- and the longer duration of assets on banks’ balance sheets, which can move both up and down in price as interest rates change. As the Fed raised rates from 0.25% to 4.75% [2] between March 2022 and February 2023, the prices of longer dated loans and securities held by banks declined, even though most of these assets would likely prove money-good. To meet demand for the withdrawal of deposits, SVB had to sell its assets at a significant loss. Looking back, these realized losses spurred panic that caused depositors to withdraw their deposits en masse.
However, unlike in 2008, it was easy to value the assets banks held in 2023. Moreover, these assets, while down in price, were, in all likelihood, not going to default. As a result, the FDIC could quickly guarantee all of SVB’s and Signature Bank’s deposits, both insured and uninsured. This action made additional bank failures less likely, and allowed the markets to calm down.
Leveraged loans sold off significantly during the banking crisis panic, but recovered ground by the end of the month
Between the day that the fears of bank failures emerged and the lowest point in March, loan prices dropped nearly 1.6 points. One day at the height of the panic saw loan prices decline nearly 0.7 points. To put the magnitude of that single-day move in perspective, the last time that loan prices fell by a similar amount was in June 2022, when the CPI measured 8.6% and the market started to price in significantly higher rate hikes.
However, as the immediate concerns about waves of regional bank failures subsided, loan prices rallied, and they ended March just 0.9 points down.
CLO liabilities widened meaningfully during the height of the banking crisis, but tightened afterwards
From the end of February to the middle of March, CLO liability spreads widened by 43 basis points across the entire CLO capital structure. However, by the end of March, much of that intra-month widening reversed. Only the AAA tranche remained wider at the end of March than it was at the end of February. Since the AAA tranche comprises roughly 65% of the CLO’s capital structure, on average the CLO capital structure widened about 6 basis points in March.
March spread movements are below [3]:
CLO Tranche Rating | February 28, 2023 (bps) | March 21, 2023 (bps) | March 30, 2023 (bps) | Intra-Month Spread Change (bps) | March Spread Change (bps) |
AAA | 167 | 208 | 180 | +41 | +13 |
AA | 225 | 275 | 220 | +50 | -5 |
A | 335 | 385 | 320 | +50 | -15 |
BBB | 535 | 580 | 525 | +45 | -10 |
BB | 948 | 1000 | 937 | +52 | -11 |
In the face of rate hikes and market volatility, CLO AAAs have preserved their value better than other AAA-rated securities
As we noted last month, CLO AAAs have not seen significant price movement amid the 2022 rate hikes and recent banking crisis because they are floating-rate products. Most CLO AAA tranches continue to trade in the mid-90s and higher, and have preserved their value far better than longer-dated fixed-rate US Treasuries, Agencies, and CMBS bonds.
March saw early signs of CLO warehouse liquidations
The typical “wait time” to go from a CLO warehouse to a CLO has significantly increased. This has disappointed some of the first loss providers, which are usually hedge funds, that had become used to waiting just 4 to 6 months.
As we have often discussed in our monthly letters, CLO arbitrage has been difficult for new-issue CLO equity since the end of 2021 [4].Today, CLO equity is so economically unattractive that it only seems to make sense for captive capital vehicles, which appear to be less motivated by attractive yields than 3rd party CLO equity investors. As a result, it takes longer for CLO managers to successfully package a CLO warehouse into an actual CLO, and the market is seeing liquidations of CLO warehouses.
Bloomberg reported on the liquidations of some CLO warehouses that were originated in late 2021 and early 2022. The first loss providers had become tired of waiting for the warehouses to be packaged into CLOs, and decided to take losses during liquidations and redeploy proceeds elsewhere [5]. These are the only liquidations we have seen so far, but if more first loss providers also decide that it’s not worth waiting for the warehouse to be converted into a CLO and decide to sell those loans, the supply of loans could put pressure on loan prices in the secondary market.
Leveraged loan issuers continued to try to reduce Credit Spread Adjustments (CSAs)
By the end of Q2:2023, all existing contracts referencing Libor will switch over to Sofr [6]. In previous letters, we addressed the continuing conflict between CLO equity investors and loan issuers regarding off-market CSAs in significant detail.
As a quick reminder, the CSAs at which all Libor contracts should transition to Sofr is well known [7]. Recommended spreads for the transition from Libor to Sofr are below:
From Libor to Sofr | AARC Recommended CSA (bps) |
1m Libor to 1m Sofr | 11.4 |
3m Libor to 3m Sofr | 26.2 |
6m Libor to 6m Sofr | 42.8 |
We believe all CLO tranches that are currently indexed to Libor will transition to Sofr with the CSAs listed above. Leveraged loans indexed to Libor should have an identical transition. We are in daily dialogue with our CLO managers to ensure they are rejecting all off-market amendments.
Footnotes:
[1] This was the 9th consecutive rate hike.
[2] Fed Funds was 0.25% on March 15, 2022 and was raised to 4.75% on February 1, 2023.
[3] Spreads from CitiVelocity.
[4] New-issue CLO equity was also very unattractive at the end of 2018 and for all of 2019.
[5] In the US market, a hedge fund called Birchlane liquidated five warehouses managed by Anchorage. In Europe, warehouses managed by Prudential, Serone Capital and Rothschild were also liquidated. Source: https://www.bloomberg.com/news/articles/2023-02-14/anchorage-liquidates-clo-warehouses-from-birchlane-takeover#xj4y7vzkg.
[6] This will include both leveraged loans and CLO liabilities.
[7] CSAs were recommended by the ARRC on March 5, 2021. ARRC stands for the Alternative Reference Rates Committee, which is convened by the Federal Reserve Bank.
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Disclaimers:
This confidential document is for informational purposes only and does not constitute an offer to sell or a solicitation of an offer to buy any securities or partnership interests described herein. This document reflects CapraCredit's opinions, views, and beliefs as of April 2023.
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