Before self-correcting, markets and investors can overreact, especially – and understandably – to unusual events like a global pandemic. After a slight pause in March 2020 and initial expectations of doom-and-gloom, the market quickly returned to the rosy, upward trends seen pre-Covid. Panelists repeatedly flagged the record-nature of current issuance, performance, and positive underlying corporate- and market-level fundamentals. On all fronts it has been “a banner year”, noted John Polito, Head of Structured Finance Sales and Relationship Management at SFVegas conference sponsor Deutsche Bank, adding that “the market has shown itself to be terrifically resilient”. 

Every part of the market for collateralised loan obligations (CLOs) – encompassing around 262 issuers and 109 managers – has seen record issuance.¹ As Q3 2021 closed, issuance already exceeded that of 2018. One panelist from MetLife observed that the tremendous growth in issuance (described by another panelist as a ‘deluge of deals’) had helped transform CLOs from an outré product to a widely-respected mainstream product.

Broadly syndicated loans (BSLs) are also on track for a record year with (so far) US$89bn of refinancing and US$101bn of resets. In the mid-market space, US$12.5bn has already been issued by 24 issuers, smashing not only the Covid-hampered 2020 figure of US$5.8bn but also the US$10.8bn issued in the previous banner year of 2019. 

Panelists from Equifax and Lending Club noted that in the consumer asset-backed securities (ABS) market the various finance providers were also busy. Indeed, some of the nimbler specialty finance players gained market share during Covid. Encompassing auto, credit cards, consumer loans, solar, and student loans, US$50bn was issued in consumer ABS in the year to 23 September 2021, up 43% on issuance for the whole of 2020, and up 14% on 2019. 

Record deals were also reported in the underlying leveraged loan market. Such growth was reported across all sectors and industries, with strong cash reserves driving investment and M&A activity. 

After the initial Covid-induced panic and expectation of increased delinquencies subsided, delinquencies have returned to their pre-Covid (and historically low) levels. This knee-jerk pessimism was also reflected in widespread credit rating downgrades, which are now seeing substantial upgrades of corporate credits.

In the BSL space, panelists did observe leverage creeping up, but noted balance sheets and cashflow remain strong. In the consumer ABS space, delinquencies were also at record lows, although investors were reported to be increasingly asking lenders for resiliency scores as they try to figure out what performance would have been in the absence of government support.

Speakers noted that while the market had – momentarily – thought the Covid crisis would be worse, three factors had helped performance:

• First, and market-wide, federal stimulus packages had helped all parties.  And regarding the mid-market more specifically:
• Second, and regarding the mid-market more specifically, lenders and sponsors helped support through liquidity support; and
• Third, the use of covenants has helped with work-outs. The resilience of mid-market CLOs and leveraged loans can be seen in the fact that, even in 2020, under 2% were placed on credit watch and under 1% (that is, only seven deals) were actually downgraded.

There was much discussion regarding the ‘shortage economy’ and bottlenecks in various product markets, such as semiconductors. 

One security analyst provided a reality check to the idea that the current supply chain bottlenecks (and over-dependence on China to which the bottlenecks have been partly attributed) could be remedied by the US decoupling its economy from China, noting that the enmeshing of the ‘Chimerica’ economy runs too deep. Another panelist (an economist) added that – aside from the cost of decoupling the world’s two biggest economies – it would not be sensible to onshore everything, and that the focus would instead be on strategic sectors.

Furthermore, the same economist made the point that the current bottlenecks were merely “reopening effects”. Such supply-chain disruptions were creating unusual short-term situations, such as second-hand cars now selling for more than new ones. These bottlenecks caused S&P to revise down its Q2 2021 US GDP growth forecast from 11% to 6% (but that is still a 37-year high).  Although the extreme bottlenecks were preventing the recovery from being felt, in reality, said the economist, the US economy is doing “rather well”.  

There was, however, a more tangible sense of concern regarding bottlenecks in the US labour market. The imbalance in supply and demand is reflected in the 5.2% unemployment rate notwithstanding the more than 10 million unfilled vacancies.² Higher unemployment benefits relative to the minimum wage, childcare challenges, and location mismatches were flagged as factors causing this imbalance.

Two interconnected aspects of government debt remained a concern for panelists:

• First, the failure of Congress to agree to an extension of the federal debt ceiling could trigger widespread defaults and far greater market harm than the Lehman Brothers collapse did in 2008.
• Second (and contingent on the first issue being successfully resolved) is how the withdrawal of Covid-based federal funding would impact the broader economy and structured finance products within that.

Given its centrality to financing, several speakers sounded a note of caution regarding the transition from the London Interbank Offer Rate (LIBOR) to the Secured Overnight Financing Rate (SOFR). New contracts must switch to SOFR from 31 December 2021, and legacy contracts must have switched by 30 June 2023.³ Speakers had hoped higher SOFR issuance would have happened already to prevent a possible ‘cliff edge’ transition, and impressed upon the audience ‘how little time there is left’.

One panelist noted four frictions likely to be experienced early in the transition process – two concerning the rate itself, and two concerning the wider market. 

• First, the current spot rates of three-month LIBOR into SOFR are such that those negotiating in the loan market will effectively be paying a higher coupon rate – a cost that will have an impact on the CLO market over time.
• Second, SOFR is a riskless rate, in contrast to LIBOR. In a downward market SOFR would act like a T-Bill, meaning that the adjustment of spread would need to come through the asset price and resulting in a CLO market that has far greater price volatility under SOFR than it did under LIBOR.
• Third, given newer CLO deals contain ‘asset replacement’ clauses (such that when more than 50% of underlying loan exposure is non-LIBOR all the remaining debt can be transitioned too), this will in due course require the basis risk between the debt and asset to be managed for legacy CLOs with LIBOR debt.
• Fourth, despite the asset replacement clauses, the fact that hundreds of thousands of LIBOR-denominated loans need to be renegotiated by mid-2023 meant that (unless all parties were proactive in trying to preempt the ‘operational log-jam’) the transition could be, said the panelist “like trying to shoe an elephant through a garden hose”.

“Demand for leveraged and syndicated loans will remain strong”
John Polito, Head of Structured Finance Sales and Relationship Management, Deutsche Bank

One panelist admitted that CLOs and CDOs had been considered to ‘have a whiff’ in the immediate aftermath of the global financial crisis. However, the excellent performance of CLOs since then has banished such doubts, and the sheer size of this asset class means it is “too big a market to ignore” and very much here to stay.

The asset class also, reflected panelists, offers investors a great way to generate alpha – not only through its out-of-index nature but also through its relative value to other products.  Even if new levels of Risk-Based Capital cause some changes to the relative share held by the usual investors; the high demand for CLOs (and structured products generally) from banks, insurance companies, and asset managers added to more recent additions such as family offices would more than meet the high levels of issuance.  As John Polito of Deutsche Bank commented, “the CLO asset class weathered the storm beautifully, and demand for leveraged and syndicated loans will remain strong.”

SFVegas 2021 took place 3–6 October 2021. The three-and-a-half day is targeted at investors, issuers, financial intermediaries, regulators, law firms, accounting firms, technology firms, rating agencies, servicers, and trustees

Sources

¹ See also the flow report on the Creditflux CLO Symposium in London, ‘A CLO renaissance’
² See also the flow report ‘Timing is all’ on the issue of US employment
³ See also the Corporate Bank news item ‘Time is running out’