U.S. CLO issuance gained traction in the second quarter, as the dollar volume of deals more than doubled after a sluggish start to the year.
In a quarterly report on syndicated lending, Thomson Reuters LPC reports that approximately $18 billion in collateralized loan obligation deals priced in the second quarter, compared to $8 billion in the first three months of the year.
‘AAA’ tranche spreads tightened to their lowest levels since October 2015, but have begun a slight climb in late June that Thomson Reuters expects to be sustained in the near term, according to its quarterly CLO survey.
Nearly half the respondents in the survey now project CLO issuance to reach about $45 billion for the full year, well below forecasts of $60-70 billion made by analysts at the end of 2015. “Obstacles to new CLO issuance remain insufficient loan supply, high liabilities spreads, challenges in placing equity, and risk retention going into effect on December 24th,” the report stated.
Risk-retention rules will require managers or sponsors of new-issue CLOs to keep a minimum 5% stake in the notional value of CLOs they issue, on the premise that “skin in the game” will better align their interests with investors.
The required retention of capital is expected to have a profound effect on the number of CLO managers that will issue deals after the rules become effective, due to the requirement to carry large levels of capital that many smaller managers cannot access. In the CLO survey, market participants projecting a 40% reduction in the number of active CLO managers by the end of 2017.
Leveraged loans issuance that sources CLO deals saw a spike in 2Q activity. Reuters reported leveraged lending of $214 billion in the second quarter was a 64% gain in volume from the first quarter. The bump in dollar volume was sparked by a 137% jump in refinancing activity in the second quarter, reaching $112 billion and up from $47 billion in the first quarter. It is the highest level of refinancing since the market saw $165 billion in volume in the second quarter of 2015.
But the outlook in that market is also clouded by the uncertainty over the market reactions to the Brexit vote, according to a CLO industry report released by Wells Fargo Securities on Thursday. In a third-quarter outlook, Wells analysts expect a “choppy summer” for loans and CLOs. “In the short term, we see investors with cash to spend, but facing a less liquid market driven by Central Banks, currencies and commodities,” the report stated.
The bank is projecting a pullback in loan issuance and concerns that the refinancing/repricing activity that was “dominating” second-quarter primary market activity will wane.
A trend that Wells expects to see from CLO investors may follow is the potential for long-term buying opportunities on mezzanine notes. Wells noted the history of those spreads recovering slowly from previous Eurozone crises.
“Longer-term investors can likely find value by buying on these dips,” the report stated. “However, we believe investors have cash to spend, and expect that some investors will attempt to compensate for missing out on buying opportunities in February 2016, and may act too soon, possibly resulting in overexposure to riskier portfolios.”
Wells also cautioned that loan downgrades, defaults and a “bifurcated” loan market of below-par prices concentrated in commodities is leading to the erosion of overcollateralization levels on CLO deals, “and holdings of riskier credits are increasing.”
Minimum OC cushions dropped by 75-100 basis points between January and May of this year.