The Federal Reserve is not rushing into a cycle of interest rate cuts anytime soon. After the Federal Open Market Committee (FOMC) meeting of 31 January 2024 left interest rates restrictive for a longer period, all eyes are now on the May or June FOMC meetings for a possible shift.

In a press conference shortly after the January FOMC meetings, Chairman Powell noted that inflation has “eased over the past year” but that the FOMC “does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably toward 2%.” Although recorded before the FOMC meeting (so March rate cut comment is out of date), Matthew Luzzetti (Chief US Economist) and Matthew Raskin (Head of US Rates Research) provide a helpful explanation on the underlying drivers of the Fed path forward in their Podzept podcast (23 January).¹

As the structured finance community gather in Las Vegas for SFVegas,² the Fed’s hawkish stance begs the question of what this all means for US collateralised loan obligations (CLOs)? To an extent, note Deutsche Bank Research CLO analysts Conor O’Toole and Jamie Flannick , Powell’s statements are beneficial for CLOs, for they imply the duration of elevated base rates will remain extended for a few months – a positive for bond holders.

In their report, US CLOs Some signs of stress, but no signs of breaking, (6 February 2024) O’Toole and Flannick look back at the position 12 months ago and conclude the outlook for US CLOs is much more positive as 2024 gets underway. As for the delay in interest rate cuts from the US central bank, they reflect that it “could provide even further price compression in both primary and secondary on top of the rapid tightening seen over the last month”.

They continue, “The healthy volume of deal activity in primary is being aided by a leveraged (lev) loan market that is also accelerating in deal activity, driven by a healthy supply-demand dynamic that has led to an outsized amount of refinancings so far on the year. The current sentiment surrounding lev loans is markedly different than it was heading into 2023, when several concerns swirled around the market.”

At the start of 2023, worries included a heightened degree of uncertainty that weighed on the leveraged loan market – the Fed had hiked interest rates from almost zero 12 months earlier to 4.35% and “it was unclear where the ceiling may be for the Fed funds rate as headline inflation remained well above 6%”.

Within this environment, loan spreads had widened to 560bps, indicating the degree of risk and uncertainty the market was incorporating into pricing due to several stressors that looked problematic for the sector:

1. Loan maturities and the ability for companies to refinance during a period of elevated borrowing cost.
2. Debt servicing costs that had accelerated due to a sharp pivot in the underlying base rate, particularly problematic for the cohort of floating-rate borrowers that had secured borrowing during a period of low rates.
3. Accelerating defaults due to shrinking EBITDA and interest coverage ratios.
4. Credit rating drift for borrowers resulting from the resulting softened financial position.

For a more detailed picture of the CLO landscape of 2023, see the flow article, ‘CLOs weathering the storm’ published in June 2023.

Although macro concerns still persist that could still dampen the economy’s trajectory – NYCB’s stock sell off at the end of January 2024 re-stoking regional banking concerns was an example,³ along with growing escalation in the Middle East and no clear path towards resolution – these broader concerns, explain O’Toole and Flannick, seem to be having “little impact on the market, while the asset-specific concerns seem to be relatively contained”.

A year on from that rocky start to 2023, there is greater clarity around each of the four risk factors set out above by O’Toole and Flannick, and although signs of stress are evident, the leveraged loan market “has yet to show signs of breaking”.

Figure 1 demonstrates how, at the end of that year, US$75bn of debt was set to mature in 2024, just north of 5% of the total US$1.4bn outstanding (loans). Twelve months later, that figure has compressed to US$10bn, which still poses a risk but at under 1% of total outstanding is significantly diminished year-on-year. The majority of the US$65bn now resides in the cohort of loans set to mature in 2028, which at roughly US$$535bn represents nearly 40% of outstanding.

Figure 1: loan maturities and leveraged loan index

Source: Deutsche Bank Research, PitchBook LCD

This provides runway for borrowers to right-size interest coverage ratios (ICRs), which have been adversely impacted by the rise in underlying base rates. O’Toole and Flannick explain, “The two are inversely correlated – when Fed funds increase, ICRs decrease. The 150bps or so of interest rate cuts being priced by the market, and even the 75bps of cuts in the FOMC’s summary of economic projections, should redirect ICRs back towards the mean in the second half of this year.”

Figure 2: Leveraged loan vs CLO default rates

Source: Deutsche Bank Research, Moody’s Investor Services, PitchBook LCD, Intex

This redirection will be beneficial for default rates, which, as Figure 2 illustrates, are trending higher across several figures. O’Toole and Flannick say, “We remain in the camp, however, that these levels are range bound due to the improved outlook for the US economy in 2024 and the dovish shift in Fed policy. The level of exposure to defaulted loans by CLOs is a fraction of the total number of loans in default, roughly 1/10th of the US Leveraged Loan Index (LLI) rate when including distressed exchanges. Active portfolio management remains a risk mitigant for CLOs when compared to investing directly in the lev loan market.”

Figure 3: Proportion of performing to non-performing loans, LLI

Source: Deutsche Bank Research

As for the credit softening seen in Q1 to Q3 during 2023, this, observed O’Toole and Flannick, “began to reverse course in 2024, with a greater percentage of performing loans (BBB-B) comprising the index compared to underperforming loans (B-/D)” (see Figure 3). This, they note, “should be particularly beneficial to amortizing CLOs, which are showing signs of increased CCC exposure”.

In short, US CLOs are holding up well. “Although signs of stress stemming from nearly two years of elevated base rates are showing, particularly when looking at stretched default and ICR levels, both remain range bound and are far from signaling that a breaking point is imminent,” conclude O’Toole and Flannick.

They see this as “a positive for the CLO market, as expressed by the constructive deal and price action visible so far in 2024”. This shift in sentiment should continue to be supportive of both CLO demand and pricing in the near-to-mid-term as the economy continues to work though the remaining hurdles left to clear in its path towards normalisation.

US CLOs -Some signs of stress, but no signs of breaking by Conor O’Toole, Managing Director and Jamie Flannick, Research Analyst at Deutsche Bank Research

Sources

¹ See dbresearch.com
² See structuredfinance.org
³ See reuters.com