The list of factors that could impact the loan-backed bond (CLO) market continues to grow. In addition to record inflation, more aggressive rate hikes, and the market’s transition from variable rate debt to guaranteed overnight financing rate (SOFR) in July 2003, the invasion of Ukraine by Russia brings a whole new level of risk and uncertainty to financial markets.
Michael Kurinets, chief investment officer and portfolio manager since 2013 at Capra Ibex Advisors, an investment and risk advisor to big names such as First Republic Bank and JP Morgan, spoke with Asset Securitization Report on how today’s changing dynamics could impact CLOs. Previously heading Credit Suisse’s secondary trading desk for CLOs and asset-backed bonds (CDOs), Kurinets sees a CLO market facing volatility that potentially presents both upsides and downsides for investments. in CLO shares in which Capra Ibex specializes.
ASR: As we head into 2022, what do you see driving the CLO market?
Kurinettes: For most of last year, what really drove credit spreads, whether high yield or investment grade, was the market’s response to covid. President Biden promised 100 million doses in the first hundred days of last year, stimulus packages, then found out not everyone was taking the vaccines, then variants of the virus emerged. The driver has since moved from the health space to the financial space, which we understand better.
RSA: Can you develop this idea?
Kurinettes: From April 2020 there was a substantial easing of interest rates, which fell [to] close to zero in mid-May 2020. But now, in response to rapidly rising inflation, we are in a rising rate environment and seeing a reversal of quantitative easing. Money is being taken out of the system and it’s hard to predict Fed rate hikes – last October people were wondering if the hikes would start in the second half of 2022 or 2023, and now they’re saying up to seven This year. This creates volatility in the market.
The switch from the Libor benchmark to SOFR was another factor. CLO activity started to pick up last August, as the year-end deadline for pricing new Libor deals approached, and people have been advancing planned deals for 2022 into 2021.
ASR: What impact has the war between Russia and Ukraine had on volatility and the loan market?
Kurinet: I see the US economy as relatively immune to the horrific shocks occurring in Eastern Europe. There may be an indirect effect due to energy prices affecting Western Europe, which is the United States’ largest trading partner, but any resulting volatility is expected to be short-term, be it a week or three. month. The weather is warming up and there are other ways to supply Europe with oil and gas by next winter. We’ll likely see high prices at the gas pump, but it’s a long way from the country entering a prolonged recession and companies not going into debt.
ASR: What will be the impact of this volatility on CLOs?
kurinettes: Volatility benefits existing CLO equity that has a significant reinvestment period remaining, as liability costs are locked in, but CLO managers are able to buy high-quality loans at lower prices. Long-term equity is designed to benefit from these types of situations and performance should not suffer.
This is not good for equity CLOs that are out of or soon out of the reinvestment period, as these trades become static and are largely valued at their liquidation values. They won’t work well because the equity of the CLO is multiplied by about 10, so for every point sold in the loan market, the equity of the CLO drops by 10 points.
ASR: So investors will turn away from CLO stocks with shorter reinvestment periods?
Kurinettes: Yes, it gets harder. For example, there was a recent bid list for shares in four different CLOs, all shorter, and none of them traded. Bids are four or five points lower than they were a month ago, and the buyer account has decided not to sell.
We pick and choose, because we think we could have near-term volatility fueled by this terrible war news, which is likely to get worse.
ASR: Will volatility have an impact on the CLO new issue market?
Kurinettes: The volume of new issues should certainly decrease, for several reasons. Once managers have enough assets in a warehouse, dealers price the AAA tranche and shares, before pricing intermediate tranches. But in times of volatility, the price of the AAA tranche changes and it is more difficult to get investors to buy big tickets.
Additionally, only a small percentage of CLO managers have captive funds for CLO equity, and those deals will close. But most need third-party investors to buy CLO equity, and third-party equity reacts immediately to what’s happening in the market and can require some pricing gymnastics. The market for new issues is therefore becoming much more difficult.
ASR: What impact will this have on the transition of CLOs to SOFR?
Kurinets: All new loans must be priced above SOFR. But as we track them, SOFR loans are de minimis, representing around 2% of the outstanding market. Legacy CLO liabilities priced above Libor switch to SOFR, typically when 50% of assets are priced above SOFR, and that seems pretty far off. But I think CLOs will eventually reach that trigger through refinances of existing loans already in transactions.
ASR: What are your prospects for refinancing?
Kurinettes: During periods of high volatility, refinancings of CLOs and leveraged loans are expected to slow due to widening credit spreads. The market now sees the basis spread between three-month SOFR and three-month Libor at around 17 basis points, which is lower than the 26 basis point fallback spread written into contracts when Libor is no longer representative and that Libor loans should change to SOFR loans. Thus, no loan originator will voluntarily make the transition before this date.
Issuers might say I’ll refinance my loan to SOFR if my overall cost of borrowing doesn’t increase, but there are legal and other costs to refinance, so that’s much more likely to happen in a period of low volatility. – when the Libor at the SOFR base spread should be lower. If the three-month Libor-SOFR base spread falls below 10 basis points, I imagine many issuers will want to reset their loans.
ASR: Will inflation have an impact on CLOs?
Kurinets: Unless inflation translates into recession and defaults, it hardly matters for CLO tranches of debt because they are floating rate.
When inflation leads to higher rates, CLO equity begins to lose the benefits of LIBOR floors. However, as rates continue to rise above the strike price on LIBOR floors, which are typically between 50 and 100 basis points, cash flow to CLO equity begins to rise again. [That’s] because 100% of CLO collateral is floating rate loans while only 90% of CLO capital structure is liability. Therefore, the cash flow from the remaining 10% of the collateral goes to the equity of the CLO.
ASR: If there were to be seven rate hikes, would CLO equity benefit?
Kurinets: It’s unclear if we’ll reach that level, as rising commodity prices could slow the economy and dampen inflation, and we don’t know how the Federal Reserve will react. But if Libor or SOFR rises to 3% or more, CLO equity will undoubtedly see higher cash flows.