UK RMBS floating above the fray
The first month of 2022 has passed, and it’s been quite a roller coaster for broader equity and credit markets, with volatility climbing to its highest level since January 2021.
We already mentioned the significant supply observed in the ABS market at the start of the year and how it was absorbed easily by investors hunting for floating rate paper. But what about CLOs?
Elevated supply characterised the CLO market during 2021, with over €100bn between new issuance and re-financings. As a result, and with €75bn forecast for this year, investors expected a solid start for primary issuance in 2022. The leverage loan outlook is reasonably benign as there’s been plenty of M&A activity, and loan defaults are expected to remain low for the next twelve months. However, the sharp moves in equities and rates fuelled by hawkish comments from central banks and heightened tensions in Eastern Europe created a challenging environment for CLO managers. At the same time, wary of the heavy pipeline, investors started the year cautiously, with many assessing the relative value by monitoring secondary activity. As a result, January saw no CLO new issue and €2.5bn of refinancing deals.
Meanwhile, looking at the leveraged loan market, the main collateral of CLOs, it’s no surprise to see loans weathering the storm exceptionally well so far. As floating rate and high carry products, loans have seen steady flows at the expense of other fixed-rate markets, expected in an inflationary and rate rising environment. As a result, loan prices held up firmly in the first three weeks, with the European Leveraged loan Index (ELLI) pushing near post-crisis highs to 99 basis points, before retracing to 98.88 last week. Overall, leveraged loans delivered positive returns of 0.4% year to date, with CCC names experiencing the biggest sell-off. On the one hand, this imbalance between supply-demand helped loan performance, but it hindered portfolio ramping in CLO warehouses, which helps explain the lower than expected supply in the market for January.
So far, the picture painted is quite rosy; the low-default loan environment, the still strong liquidity available to corporates and the floating rate nature of loans should provide significant support for CLOs. The key question for us is whether this picture reflects what we have experienced in our market thus far?
Partially, yes. Despite the slow primary start, secondary market activity was elevated throughout the month and absorbed well, with little impact on levels, thus signalling demand for CLOs exists. Meanwhile, sub investment-grade spreads, which are more sensitive to credit risk and more correlated to broader volatility, felt a bit softer last week, with longer duration profiles suffering the most. However, BB-rated profiles traded at yields around 6.5%, not far from the levels experienced at the end of last year.
Meanwhile, four new issues are set to price this week, and we expect announcements for another four. From our vantage point, early indications suggest strong demand for investment grade tranches, which appear well covered. For instance, AAAs are mostly anchored with a coupon of 92 basis points; four basis points tighter when compared with spreads in Q4 2021. Moreover, we heard that more treasury banks and new investors entered the market this year, further bolstering demand. At the same time, BBB tranches are trading with coupons of 325-330 basis points, which is marginally inside December prints, while uncertainty is more prevalent in sub investment grade tranches due to broader volatility. Still, market interest seems present for BBs, yielding around 6.4-6.5% and Bs yielding 9.35-9.5%, in line with Q4 21 levels.
Certainly, there are still catalysts with the potential to change risk sentiment, and we don’t think CLOs are immune, especially for tranches lower down the capital structure. However, the current rate and default environment should support the market, and we expect investment grade tranches to remain well bid. At the same time, sub-investment grade spreads might widen in line with broader volatility. Even so, we believe investors can pick their spot and find compelling opportunities and still expect CLOs to be among the best performing asset classes for 2022.