After a shaky start to the year, CLO issuance is now running at nearly the same pace as 2018. The nearly $13 billion in new deals in February brought year-to-date volume to $18 billion, just shy of the $21.4 billion issued in the first two months of 2018.
But spreads on securities issued by collateralized loan obligations remained flat or slightly widened across the capital stack during the month, according to a monthly Wells Fargo market research overview. The average spread on AAA rated CLO securities issued in February was 133 basis points over Libor; that was 12 basis points wider than the 121 basis points average reported by Refinitiv for December, but still well wide of 98.14 basis points in March 2018.
A number of CLO managers have responded by issuing deals with unusually short life spans – as short as one year, compared with a more typical four- or five-year reinvestment period before amortization – in order to reduce their funding costs.
On Feb. 13, Voya Asset Management issued the $399 million CLO with a one-year reinvestment period, in exchange for which investors accepted a spread of just 117 basis points over Libor.
The same day, BlackRock Financial Management printed a $500 million CLO that has a reinvestment period of three years and can be called, or repaid early, as soon as one year after issuance. (The collateral for the deal also has maximum weighted average life of seven years, compared with an average maximum WAL of 8.5 years for CLOs rated by Fitch Ratings in the fourth quarter.) The spread on the senior notes is 128 basis points on the triple-A rated notes.
Market difficulties “always lead to some sort of innovation,” said John Nagykery, a team lead for CLOs at Morningstar Credit Ratings said at a Structured Finance Industry Group conference in Las Vegas last week. In addition to shorter reinvestment periods, Nagykery said Morningstar has received inquiries on other “bespoke” structures including principal protected notes, collateralized fund obligations, and CLOs that use both loans and bonds as collateral.
There are a number of factors impacting CLO spreads. CLOs and other floating-rate assets have lost some of their allure with investors now that the Federal Reserve appears to have stopped raising interest rates. This makes fixed-rate investments relatively more attractive.
There may also be residual concerns about the riskiness of leveraged loans, as regulators continue to harp. Former Federal Reserve chair Janet Yellen, who spoke in a closed session at the same industry conference, expressed her concerns that leveraged loans have been weakened by “egregious underwriting deficiencies” and that lenders’ weaker covenant restrictions on corporate borrowers, could be a cause of another economic downturn, according to participants.
It’s also possible that some Japanese investors, who are big buyers of the senior tranches of securities issued by CLOs, are sitting on the sidelines until Japan’s Financial Services Agency finalizes proposed rules that could impose onerous capital burdens on holdings of CLOs whose managers don’t retain skin in the game of their deals. The rules could have a dramatic impact on the U.S. market, though regulators are expected to carve out an exemption for most CLOs.
And now that CLO spreads have widened, refinancing activity has slowed, which in turn is contributing to the slowdown in new issuance, according to Gretchen Lam, a senior portfolio manager for Conning’s Octagon Credit Investors. Last year, investors had to replace holdings in $83.8 billion in CLO securities that were refinanced or resets, which involve managers transferring collateral for existing deals to new deals with longer terms. “If you were an investor in AAAs [last year], you were running in place a lot” selling and buying CLO paper, said Lam. But “you don’t have that right now.”
Whatever the reason, it’s unattractive for many managers to issue new deals with CLO spreads at current levels. The collateral for new deals is typically assembled over a period of weeks or months using what is known as a “warehouse” line of credit. When the loan market tanked late last year, a number of managers were in the process of warehousing loans; the violent selloff in November and December left them holding assets worth less than what they paid for them.
And since prices of CLO securities have also fallen, it’s less attractive to “term out” this warehouse financing by selling the loans to a securitization trust. The bonds that would be issued to finance the purchase of the loans might not fetch enough to recoup a CLO manager’s original acquisition costs. Even in some cases where managers could recoup their initial investments in the loans, the yield on the assets might not be sufficient to adequately compensate holders of the riskier tranches of notes to be issued.
“Any new CLO warehouse is thirsty [for loans] at these low prices, but existing warehouses that were pretty fully ramped [before the loan selloff] might not necessarily have the ability to (execute a deal). Their portfolios are slightly under water,” said Kevin Kendra, a managing director at Fitch Ratings. “There’s still strong investor demand for the asset class at the top of the capital structure; the hard part now is reconciling the equity part of equation.”
Structuring a CLO with a shorter life span is one way for CLO managers to lower their funding costs, if investors are willing to accept narrower spreads in exchange for getting their principal back sooner. And shorter noncall periods give them the opportunity to refinance should market conditions improve.
PGIM Fixed Income was another issuer sponsor a short-term new-issue CLO, when it closed a $428.8 million portfolio on its Dryden platform in January with a six-month optional redemption date and one-year reinvestment period. Assurant CLO Management also priced the $450 million Assurant CLO IV with a three-year reinvestment/one-year noncall window.
Other CLO managers appear to be taking a wait-and-see approach, holding out for better market conditions, something that is possible because warehouse lines typically have legal maturities of one or two years. DBRS, which rates some CLO warehouse lines, noted that CLO warehouses typically have six- to nine-month durations, and so these are going out to nine to 12 months. “Rated warehouse terms aren’t necessarily extending, but we see actual warehouse durations stretch longer,” said Jerry Van Koolbergen, a managing director and structured credit analyst with DBRS.
Smaller CLO managers who are underwater on warehouse lines may have an even harder time securitizing because investors are currently demanding additional compensation from them than they are for CLO securities issued by larger, more established managers. The triple-A rated tranches of CLOs from smaller and newer managers issued in February has spreads in the high-140/mid-150 basis point range, compared to established managers who are pricing deals at 133-136 basis points, according to Wells Fargo.
Take Los Angeles-based TCW Asset Management, on Feb. 13, the manager priced its fifth transaction – and the first in two years – the $403 million TWI CLO 2019-1 AMR: the deal has a two-year reinvestment period and is noncallable for one year, yet the triple-A rated senior tranche still pays a hefty 144 basis points over Libor. Moreover, this rate steps up at the end of its noncall period and reinvestment period.
AIG, which returned to the CLO market after a decade-long hiatus, issued its first deal of 2019 with a spread of 142 basis points. That was well wide of the 132 basis point spread over Libor it gained for its debut deal that priced only two months prior.
But even top-tier managers are issuing CLO securities at spreads far wider than they were a few months ago. In February, Octagon Credit Investors priced its $606 million Octagon Investment Partners 24 with a triple-A tranche that pays 133 basis points over Libor for its AAA notes – compared with its previous deals in 2018 that landed a 115 basis point spread in October and 108 basis points in July. On Feb. 21, the Carlyle Group issued the $602.7 million Carlyle US CLO 2019-1 with a triple-A tranche that pays 132 basis points over Libor.
Both firms are among the 10 biggest U.S. CLO managers.
The good news is that for managers who can start warehousing loans from scratch, leveraged loan prices have recovered significantly from the fourth-quarter selloff. CLOs and warehouse lines have absorbed the $40 billion to $50 billion in outstanding loans at the beginning of the year, and are equipped to handle the $30 billion in year-to-date issuance in net new supply, said Lam.
"The pig has come through the python, for the most part, in the first quarter," she said. "Clearly the retail funds are playing a less prominent role in the new-issue loan allocations we’ve seen so far in 2019, [and] CLOs have really picked up the pace of participation in those new deals."
