Despite potential regulatory hurdles and dire reports on the decreasing quality of assets backing collateralized loan obligations, structured credit experts said they see almost no letup in investor demand in the foreseeable future.
Echoing recent forecasts for another banner year for CLO issuance, several investment leaders speaking at an industry conference April 22-23 saw nothing standing in the way of volume totaling between $60-70 billion in 2014—notwithstanding the near standstill in the market in January, when investors fretted over the potential impact that Volcker Rule compliance would have on bank holdings.
“It’s eminently doable,” Amit Roy, vice president and head of CLO structuring for Goldman Sachs, said at Information Management Network’s Investors Conference on CLOs and Leveraged Loans.
New Triple-A Investors, New Managers
Roy and other panelists cited the increased demand for the senior tranche of CLOs from investors like pension funds, as well as the surge in first-time issues from smaller, independent managers taking a stab at CLOs. They also cited investor confidence in the stability of CLOs.
These sentiments were in sharp contrast to the warnings issued by many participants about the impact of new regulations as well as the negative portrayal of CLOs in some recent media reports, which have drawn the ire of the likes of Babson Capital Management chairman and CEO Tom Finke.
“The good news is the continued press has not caused these new investors to shy away from participating in the AAA market and CLO market,” said Mary Katherine DuBose, a managing director at Wells Fargo. “The statistics and historical performance will continue to show that the asset class has performed irrespective of where covenants may be going and where leveraged loans may be going.”
On April 2, Wells Fargo upped its forecast for CLO issuance this year to $80 million-$90 million. That forecast was largely based on expectations that banks would continue to be able to invest in these securities.
A previous forecast, published in early December, called for issuance of just $60 billion.
The primary market got off to a slow start to the year, largely because the Volcker Rule, published in December, makes it difficult for banks to hold the senior securities issued by CLOs. Volcker prohibits banks from having “ownership interests” in securitizations of any assets other than loans.
This creates two problems: Most CLOs have some exposure to corporate bonds, as well as loans, and the senior debt tranches of these deals have some equity-like characteristics.
Just $21.8 billion of CLOs were issued in the first quarter of this year, according to Thomson Reuters LPC. That was down 20% from the fourth quarter of 2013. However, the pace has picked up considerably, as that volume was heavily weighted toward February and March.
At the beginning of April, regulators announced a two-year extension to the deadline for banks to get their CLO holdings in compliance with the Volcker Rule. These institutions now have until July 2017 to shed more than $70 billion in CLO securities that they are prohibited from holding.
Credit Strong, Prices Cheap
Algis Remeza, a senior vice president at Moody’s Investors Service, said that several credit factors have made CLOs attractive. He cited the default rate for the speculative grade loans collateralizing deals, which was just 1.71% in the past year and is projected to remain well below the 4.7% historical average since the 1980s. Contributing to this trend is the strong liquidity in the leveraged loan market, which has spurred a binge of refinancing, thereby reducing default risk by lowering corporate borrower’s debt servicing costs.
CLOs also have a long track record of healthy performance: Less than 2.5% of all tranches of CLO assets have become impaired since Moody’s began rating them.
CLOs, both those issued before the financial crisis and those issued post crisis, also remain over-collateralized, Remeza said. Another factors driving new issuance include the development of CLOs tailored to new investors. For example, transactions tailored to the specific currency needs of triple-A investors are starting to emerge.
Another factor contributing to demand for CLOs is simply cost. “CLOs are cheap,” said Oliver Wriedt, co-president of CIFC Asset Management. “I think it’s the only way to explain this tremendous volume that we’ve seen yet again.” Even with the slow start to the year, Wriedt said his firm is ahead of last year’s pace in terms of both number of deals (five more than year-to-date 2013) and volume (up $2.7 billion year-on-year).
While new loan issuance is the driver CIFC’s CLO issuance, in terms of value, CIFC is keeping its eye on the secondary trading market for loans that, “CLO issuance notwithstanding” are underperforming on a total return basis, Wriedt said.
“We anticipate there will be buying opportunities in the secondary,” said Wriedt, “where we can begin to build portfolios not just around aggregating new-issue collateral, but really take advantage of some volatility in the secondary market, perhaps for first time since the summer of 2011.”
Goldman Sachs’ Roy says that most market participants have a “bullish” short-term outlook on credit.
“Over the last couple of months, we’ve seen a little bit of easing of demand for the underlying loans, which has improved the actual picture a little bit for CLOs,” Roy said.
“And you’ve seen triple-A [CLO] spreads beginning to compress — [but] nowhere near as dramatic as some folks might have expected.” Senior tranches of recent deals have priced at spreads of 145-150 basis points over Libor, compared with recent highs in the 155-160 basis point range.
Wells Fargo also cited the “good relative value” and “a quality performance history” of CLOs in its revised issuance forecast. Other factors that will drive new issuance include the possibility of $40 billion - $45 billion in “runoff” as older CLOs pay down or are called; a large number of managers looking to issue deals; and the possibility that “onerous” risk retention rules will take effect in 2016, which may push issuance forward.
However, the report cited several possible headwinds to increase primary volume this year, including: “less market depth” compared with other sectors of the asset-backed market, especially for triple-A rated securities; pressure on returns of CLO equity securities, specifically due to outsized retail demand for loans; and the resulting disconnect between spreads on senior CLO tranches and spreads on loans backing these deals.