Newsletter June 2023

In response to slowing US inflation readings and a more ‘wait and see’ approach from the Federal Reserve, the recent move higher in risk assets is broadening out. This follows a relatively muted performance in May, except for equities linked to the growing euphoria in artificial intelligence. In bond markets, expectations for rate cuts are finally being pushed out, whilst elevated inflation and signs of accelerating wage growth is causing some yields to move sharply higher e.g., UK 2-year rates at 5% from 3.5% in April. Naturally, expectations are high for interest rate sensitive sectors to struggle and despite a manufacturing recession already underway in Europe and the US, overall economic growth continues to confound expectations, driven by firm employment conditions and strong services demand. If such an environment prevails, those hoping for a pause or slowdown in rate increases should note the recent surprise decisions by the Bank of Canada and Reserve Bank of Australia to start hiking again.
 
In credit markets, the story is about a strong technical backdrop on the one hand, and concerns about rising credit stress on the other as base interest rates remain higher for longer. On the technical side, European CLO issuance at EUR 5.4bn has far outweighed net new leveraged loan supply of EUR 3.5bn over the last three months to May. Whilst the US leveraged loan market has been singled out as an area that requires careful monitoring, the situation is nuanced when it comes to credit risk, with prices ranging from 87/8 for the weakest CLOs to 95/6 for the strongest. With more aggressive credit underwriting in the US coupled with a more litigious environment potentially harming first-lien recovery rates, there is a strong case for Europe to outperform, not to mention the greater credit enhancement when considering CLO investments in Europe.
 
Despite some caution following the recent spike in UK gilt yields (for fear of an LDI re-run), demand continues to be robust especially for higher quality CLO exposure in the secondary market. This was confirmed at the recent Global ABS conference that we attended, where the mood was generally upbeat when it comes to credit performance and refinancing options for borrowers. However, there was also frustration about the poor CLO equity arbitrage resulting in limited interest from third-party buyers and the lack of new loan supply which adds to the challenges of new CLO formation. As managers are forced to buy loans in the secondary market, this benefits our funds as coverage on our debt positions improves. Furthermore, debt coupon rates are at historical highs given Euribor levels and we expect better equity distributions once the Euribor mismatch between assets and liabilities fades.