I’ve noticed a number of things happening across the credit ecosystem of late. Namely, the syndicated loan market being largely muted versus its 2021 self, the reasons for it, and implications.
To start, Oaktree outlined why the AAA tranches of CLOs have lost their bid.
As the Fed added over $4.6 trillion in assets to its balance sheet in 2020–21, it also accrued liabilities representing the same amount. This meant banks were flooded with excess reserves (i.e., capital above the amount that regulators require private banks to hold on deposit at the central bank). These reserves earned almost no interest, so banks dealt with this glut by using that capital to buy safe assets that earned slightly higher interest rates, such as AAA-rated CLO tranches. This is one of the main reasons why CLO primary market activity soared to record-breaking heights in recent years.10
Oaktree
The letter goes on to explain the effect:
In March, the Fed ended its quantitative easing program, meaning it is no longer seeking to be a net buyer of assets. Banks therefore aren’t regularly accumulating reserves and thus no longer need to buy assets like AAA CLOs. Moreover, the Fed is now also paying a higher interest rate on reserves, and Treasurys are offering higher yields, so CLOs look less attractive by comparison.
Oaktree
And the conclusion:
Consequently, demand has declined for low-risk CLO tranches, which make up roughly 65% of each CLO, and CLO primary market activity slowed accordingly in the first quarter.11 CLO managers have therefore been forced to offer wider yield spreads on AAA tranches in order to complete deals, even though the underlying credit fundamentals of CLOs remain strong.
Oaktree
So overall, Oaktree is saying that the AAA market for CLOs doesn’t have the bid that it had prior because of Fed tightening, and the banks don’t have to reach for safe yield anymore (because the Fed has stopped buying up the safest assets from them, like treasuries or agency MBS). This is compounded by the fact that banks have loans on their balance sheet that were meant to be syndicated, in large part via CLOs, that they are hung on. Moelis and Company outlined:
The banks are strong. The nonbank market is strong. But right now, the nonbank market is focused on transactional loans that the banks have and they’re being offered at the clearance aisle, 10%, 20% off. And I just think that’s just a natural, yes, I think that those are going to get cleared out because they’re onetime, and then we will reset and the banks will be in business. By the way, they’ll be in the new federal funds rate, I get it, there’ll be higher interest rates. There might be lower leverage, but they’ll be back in business. Right now, there’s a fundamental almost not working transactional market as the clearance sale happens.
2Q22 MC Earnings Call
It looks like the large cap direct origination market is widening out on a spread basis as a result. Remember, CLOs are filled with non-investment grade loans so if banks are choking on their inventory, and there are fewer buyers for 65% of each CLO (the AAA tranche), not many non-IG loans can get done through this pathway.
As a result, Apollo’s large cap lending strategy (disc: we are allocated to this) has seen its spread over LIBOR / SOFR on new origination expand meaningfully over the past months:
1Q22: 530 bps (ADS commentary)
2Q22: 591 bps (ADS commentary)
Mid 3Q22: 650 bps (APO earnings call)
This is material widening in the context of what Apollo’s middle market vehicle (MFIC) has experienced:
1Q22: 612 bps
2Q22: 622 bps
On the MidCap earnings call, I asked about this contrast in movement between large and middle market lending, as one would think that smaller companies on average should be less creditworthy. Thus more spread widening than large cap lending.
The answer (no transcript yet) effectively said that because the broadly syndicated market is muted, in part due to the above lack of buyers, competition has lessened for large cap direct lending versus middle market direct lending, which did not depend on the CLO market in the same magnitude.
So where is the opportunity? It seems like clearly large cap lending is a target rich environment within credit. Apollo went on to say:
As a result of the lack of capital availability in these markets, private credit continues to experience strong demand from financial sponsors and companies.
For context, the weighted average yield at amortized cost of directly originated large cap loans in our portfolio was 8.0% as of July 31, 2022, and the yield at amortized cost of opportunities our near-term pipeline ranges from approximately 8.5% to 10.5%. Aside from the tailwind of rising interest rates, we believe that our ability to build a new portfolio of directly originated large cap loans in this environment enhances the pace at which we are able to increase our overall portfolio yields.
Based on our current pipeline and portfolio activities, we expect liquid loans to become a minor portion of our portfolio [as direct origination is increased] in the fourth quarter.
ADS July Commentary
Moreover, my mind is thinking about whether this stoppage in the broadly syndicated loan market is more weighted toward being the result of Fed actions or oversupply of hung inventory. If it is the former, perhaps we see permanent spread widening that starts to make its way to the middle market as well. If the latter, the large cap lending opportunity may be a short window.
As usual, time will tell.