By Mike Kurinets, Chief Investment Officer
Key Takeaways:
For most of April, the markets’ concerns over the regional banking crisis subsided. For the bulk of the month, the markets behaved as if the regional bank crisis was over. However, on May 1, First Republic Bank was taken over by the FDIC and sold to J.P. Morgan. In light of this news, many of the concerns that dominated the markets in March returned.
Inflationary measures eased in April. The YoY CPI came in at 5% vs 6% in March and the MoM CPI came in at 0.1% vs 0.5% in March. Both measurements indicated a slowing of the economy, and an approaching end to the rate-hike cycle. Even so, the Chairman of the Federal Reserve warned that the battle to tame inflation is not over, and he failed to indicate that the Fed could begin to lower rates in September, as the market has assumed.
Japanese banks returned to the CLO markets. With Noriunchukin and Sumitomo Life buying entire CLO AAA tranches, some may think that CLO liability spreads will tighten.
Leveraged loan prices rose slightly in April. Much of the April loan price increase was carried over from the recovery at the very end of March (when the markets assumed that the regional bank crisis had ended).
CLO liabilities tightened slightly in April. Throughout April, the spread on new-issue liabilities barely changed and was roughly 4 to 6 basis points tighter.
CLO equity cash flows significantly increased in April and returns on most CLO equity were positive. Quarterly cash flows to CLO equity increased dramatically in April from those in July, October, and January. Combined with slightly higher loan prices in April, most CLO equity positions had positive returns in April.
Towards the very end of April, concerns over regional banks reignited
After Silicon Valley Bank and Signature Bank both failed within days of each other in March, various government agencies worked closely with the nation’s largest banks to reassure depositors that their money would be safe and dispel concerns that other regional banks would fail. By the end of March, rumors began to circulate that First Republic Bank was no longer looking for a buyer.
For most of April, the market seemed to believe that the regional banking crisis had ended and that there would be no additional failures. However, on May 1st, the FDIC seized First Republic and sold it to J.P. Morgan.
The loan market then began to steadily move lower -- though in an orderly fashion. The market seemed to assume that, although other regional banks might fail, their failure would not ultimately lead to a repeat of the 2008 crisis, at-risk deposits, or a hard landing for the overall economy (stemming from lower credit availability).
Japanese financial institutions returned to the U.S.$ CLO market
Japanese banks have exited and re-entered the U.S. CLO market several times over the last 5 years. While they are a significant presence because they often take up to 100% of the entire AAA tranche at spreads tighter than where the market is clearing, dealers have been successfully syndicating AAAs among U.S. and European institutions.
In the past, when the Japanese institutions exited the U.S. CLO markets, spreads on CLO AAAs did not significantly widen. We don’t anticipate that spreads on CLO AAAs will significantly tighten with the Japanese buyers coming back in, but they will lend support to new-issue CLO execution for the certain CLO managers approved by the Japanese buyers.
It seems reasonable to infer that Japanese investors are returning because they see value in CLO AAAs. Last month, we highlighted how CLO AAAs have preserved their value better than other AAA-rated securities. They did not see significant price movement amid the 2022 rate hikes or the recent banking crisis as they are floating-rate products and broadly considered to be very resilient in avoiding default. 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.
Leveraged loan prices rose slightly in April and did not see significant daily moves
For most of April, loan prices rose at a very slow pace. By the start of the fourth week of April, loan prices were up about 0.34 points. However, after J.P. Morgan bought First Republic Bank, loan prices began to slowly decline. Though it’s not conclusive that the failure of First Republic is the reason that loan prices reversed course, in the last four days of April, they dropped by 0.12 points and have not had an up day as of mid-May.
CLO liabilities tightened slightly in April
While there was an overall slight tightening in CLO liabilities during April, some reports show that parts of the capital structure widened. Compiled data likely reflects these inconsistent trends because deal volumes in April were lower [1] and overall spread changes were not significant.
No CLOs were refinanced or reset in April.
April spread movements are below [2]:
CLO Tranche Rating | March 30, 2023 (bps) | April 28, 2023 (bps) | April Spread Change (bps) |
AAA | 180 | 172 | -8 |
AA | 220 | 230 | 10 |
A | 320 | 305 | -15 |
BBB | 525 | 535 | 10 |
BB | 937 | 930 | -7 |
Loan investors were increasingly united in rejecting proposals to convert loans from Libor to Sofr at below-market Credit Spread Adjustments (CSAs)
In previous monthly letters, we have described the battle between CLO equity investors and loan issuers regarding off-market CSAs. While the battle continues, we are happy to report that CLO equity investors have made substantial progress in creating a focused and organized resistance to off-market CSAs. All of the CLO managers we have been systematically contacting [3] have implemented policies to automatically reject any proposal to convert a Libor loan into a Sofr loan at a CSA that deviates from the officially recommended levels [4]. Recommended spreads for the transition from Libor to Sofr are below:
From Libor to Sofr | ARRC Recommended CSA (bps) |
1m Libor to 1m Sofr | 11.4 |
3m Libor to 3m Sofr | 26.2 |
6m Libor to 6m Sofr | 42.8 |
Cash flows to CLO equity increased in April
On average, cash flows to CLO equity in April 2023 increased by about 50% from those in January 2023 and October 2022 [5]. The main reason for the increased cash flow is the decreasing difference between 1-month Libor and 3-month Libor rates as the economy nears the end of the Fed’s rate-hike policy.
From March to November of 2022, the difference between 1-month and 3-month Libor exceeded 50 basis points [6]. This resulted in lower cash flows to CLO equity because up to 70% of loans are indexed to 1-month Libor but all CLO liabilities are indexed to 3-month Libor. As a result, when 1-month Libor is significantly lower than 3-month Libor, loans indexed to 1-month Libor produce significantly lower cash flows and less cash is available to pay CLO equity, which receives all excess cash flow in a CLO.
Going forward, we expect that the difference between 1-month and 3-month Libor to remain relatively low and therefore cash flows to CLO equity should remain high.
Footnotes:
[1] According to Pitchbook LCD, only $6.4 billion in CLOs were issued in April. For comparison, April is the lowest issuance month of 2023 and, on average, $10.7 billion were issued each month in 2022.
[2] Spreads from CitiVelocity.
[3] Each time Capra Ibex learned of a proposal to convert a loan from Libor to Sofr at CSAs below the ARRC recommended levels, we have immediately contacted all CLO managers that own the loan across our investment portfolios.
[4] 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.
[5] CLOs distribute cash flows quarterly. Approximately 85% of CLOs pay in January, April, July, and October.
[6] From January 2010 to April 2023, the median difference between 1-month and 3-month Libor has been 11 basis points.
Forward Looking Statements:
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