CLO issuance has been surprisingly robust in 2015, but as many industry participants observed at an industry conference in New York last week, it’s likely that the market will be tapping the brakes before the year is out.
Participants pointed to the growing impact of regulation and the narrowing supply of new loans as signs that issuance of collateralized loan obligations might not top last year’s all-time record of nearly $124 billion.
While CLO issuance has been charging along at the same pace as last years, with nearly $37 billion printed through mid-April, issuance of below investment grade corporate loans is down 30 to 35%. “That fundamental imbalance isn’t sustainable,” said Amit Roy, vice president in Goldman Sachs’ fixed income division and head of collateralized loan obligation structuring.
Roy was among several panelists assessing a cloudy outlook for the market at the conference hosted by Information Management Network.
Roy’s thoughts were echoed by Jason Powers, a managing director and co-head of origination and capital markets at Wells Fargo Securities. “I think loan supply is crucial right now,” said Powers. He noted one of the major bottlenecks for issuance of corporate loans is leveraged lending guidance issued by banking regulators in 2013, which restricts large banks from taking on highly leveraged borrowers (those with a debt to Ebtida above 6x).
Slow loan issuance doesn’t just make it hard to source collateral for CLOs, it also makes what collateral there is more expensive. In the secondary market, some 60% of loans are now trading above par, compared to only 25% in 2014.
There’s been a “tremendous rally on loans that’s put a damping effect on CLO market arbitrage,” said Powers.
“And the dynamics around risk retention don’t help matters,” added Roy, referring to rules that take effect in December 2016 require CLO managers to hold on to 5% of the notional value of their deals.
With loans so scarce and expensive, why has CLO issuance been strong so far this year? The primary reason is that there are still managers that obtained warehouse lines of credit from banks to acquire loans in the fourth quarter of 2014 that have yet to securitize these assetss.
Tightening supply and risk retention will both have a bigger impact on smaller managers, panelists noted.
CLO investors may also become scarce, making it more difficult or expensive to find buyers for deals that do make it to market, as Wells Fargo research analyst David Preston wrote in a report following the conference. “CLO investors face unique costs such as regulatory burdens, less total return potential, optionality which can lead to a minimum basis between spreads of CLO AAA’s and competing assets,” Preston wrote.
One of the concerns for CLO investors in recent years has been the declining credit quality of the loans packaged into CLOs, as pointed out in opening session remarks by Algis Remeza, a senior vice president at Moody’s Investors Service and manager of the CLO rating team at the agency. But Remeza said many factors that have pointed to growing risk within CLOs including a rising median weighted-average factor (WARF) of CLO 2.0s and the growing percentage of single B’-rated corporate borrowers within Moody’s speculative-grade universe are beginning to slow, if not abate.
Remeza noted that WARF figures for CLOs have flatlined at about 2750 for the last two years, after spiking up from 2500 between mid-2012 mid-2013. (Moody’s WARF ratings are a numerical attribution of the credit risk of a securitized portfolio. Higher numbers indicate more lower-graded corporate borrowers are included in a portfolio, with a move from 2500 to 2750 being equivalent to a downgrade shift from a lower B1’ rating to a mid- B2’ rating).
In addition, the percentage of single-B’ rated companies (those rated B3,’ B2’ and B1) within the Moody’s speculative-grade universe have fallen below 80% in the early part of 2015, after topping that level in the spec-grade ratings distribution for the past four years.
Meanwhile, the average debt-to-Ebitda of leveraged-loan issuers has settled at 5.08x in 2014 after rising to 5.10x in 2012 (it was below 5x the previous five years, including 4.52x in 2007). Global CLO subordination remains strong, with the average loss rate hovering at only 0.12% for the past year across all tranches, according to Remeza.
One worrisome area remains with a continued deflation of the debt cushion in the leveraged lending space. According to Moody’s figures, the cushion below the first-lien cov-lite loan level (i.e., cash flow after debt servicing) has shrunk from 33.15% (2010) to 21.07% in early 2014.
Among other issues making CLOs less attractive is the large number of deals being refinanced as a result of another Dodd-Frank regulation, the Volcker Rule. This prohibits banks, which are big buyers of CLOs, to have an ownership interest in deals that have bonds, in addition to loans, as collateral.
This is prompting a wave of refinancing of existing deals to get them into compliance. According to Remeza, there is a knock-on effect on credit quality. That’s because investors in the most subordinate tranches of these deals are using the opportunity to negotiate larger cov-lite and second-lien baskets in CLO tranches along with longer reinvestment periods all of which are negative for investors in senior tranche investors.