Liability spreads in the ABS CDO market may continue to push out as issuance remains at a standstill. But with the pickup in new deals in the CLO sector, similar widening appears to have ended with the third quarter.
While one CLO analyst said that there has not been much change in liability spreads at the top of the capital structure, he saw spreads on more subordinated pieces coming in a bit. Indeed, single-A CLOs have tightened five basis points, to 240 basis points, and triple-B CLOs are tighter by 10 basis points, to 430 basis points, according to a recent report from Deutsche Bank. The report also noted that while spreads on triple-B CLOs widened to 825 basis points in mid-September, they have since come in by 15 basis points, ending the month only 10 basis points wider than at the end of August.
Ares Management reported pricing of Libor plus 63 basis points on its latest $750 million transaction, which suggests that investor support is in the mid-60 basis-point area for AAA' CLO paper, according to a recent report from UBS, which noted that the Ares transaction was actually 2 basis points inside price talk.
"While the forecast is not clear skies yet, perhaps there is a break in the clouds," UBS said. The bank's leveraged loan desk reported better buying early this month by a 4-to-1 margin, adding that forced delevering and warehouse unwinds appeared to be slowing.
A factor in the rally of the CLO market over the ABS CDO market has been the tested nature of the vehicle. Indeed, this is not the first time that the CLO market has made a recovery after a bad spill, market participants said. They point out that CLOs lived through a previous cycle and have been fairly resilient to credit problems in the underlying asset class. Few deals are failing credit tests, despite the fact that the favorable credit environment of 2006 and 2007 allowed for "record levels of covenant lite' collateral," Deutsche Bank noted.
The ABS CDO market, however, has never had to navigate severe tests before this current slump. Further, while the CDO market is suffering from true fundamental credit problems, the CLO market shut down this summer due to liquidity issues and a general repricing of risk, market participants agreed. "When people calm down and take a look at how they expect these structures to perform through a cycle, CLOs look much more favorable from a risk-reward perspective," said James Grady, senior portfolio manager for structured finance securities at Deutsche Asset Management. Others agreed.
"You are starting to see people differentiating between the credits now," said Gilbert Liu, attorney at Baker & McKenzie. "We are going to get more CLOs done, but they are probably going to be more expensive than they were a year ago." Indeed, while the market does not expect liability spreads to return to their tight presummer levels, investors returning to the sector should continue to firm spreads. "I would not expect [spreads] to come racing in, but we will see more liquidity flow to the sector, and spreads will be tighter than they were recently," Grady said.
Swooping in on Debt
The market also expects to see more plain-vanilla transactions for the remainder of the year, as managers focus on luring back liquidity. "If the issuers start creating these simpler structures - more of the old basic structures - you are going to be able to widen your investor base, and I think you will see people crossing over looking for good deals," Liu said. "Good deals that they can understand and they do not have to worry about too many bells and whistles."
Players moving into the CLO sector include opportunity funds and other distressed-debt investors looking to take advantage of the dislocation in the market. As one market participant noted, CLO spreads were so wide that so-called vulture funds expressed interest in some of the Baa'-related tranches. On the CDO side, opportunistic investors have also started buying up pools of RMBS collateral at large discounts, as well as the equity or lower-tranche bonds, looking for good arbitrage opportunities, said Liu. He expected that this strategy would continue through the fourth quarter and into the first quarter of 2008, which should bring some activity back to the market.
"As that stuff starts moving around, I think the markets will loosen up a little bit," he said. "There will be a little more liquidity in the market, and people will start to feel more comfortable."
But with the CDO market still focused on risk containment and loss mitigation rather than new issuance, the heightened investor scrutiny casts skepticism on just how much of the CLO market will come back and when.
"The big concern is that with 60% of leveraged loans placed into leveraged loan vehicles, if buyers don't come back, or they come back at remarkably wider levels, that makes financing for these levered companies more expensive and fundamentally unavailable," Grady said.
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