With looming risk-retention rules less than two months away, collateralized loan obligation managers may push refi levels to new heights before the year is out.
In a quarterly CLO market report issued Wednesday, Moody’s Investors Service said the deals and volume level of refi’s and so-called “resets” of existing CLO portfolios will reach post-crisis highs, as managers rush to beat a late December deadline when federal risk-retention standards go into effect for the asset class.
The agency didn’t offer any projections, but stated that “[b]ased on our current ratings pipeline, we expect that refinancing volume will be strong through the rest of the year and that 2016 will be a post-credit crisis record year for refinancings.”
The expected refi volume boom comes after the market saw a blockbuster $8.4 billion in refinance and reset volume last month, more than half of the year-to-date refi totals of $16.3 billion in 43 deals through Oct. 31, according to Thompson Reuters LPC.
The refinance activity to come will be in addition to a crush of expected new-deal issuance that managers will also race to the market to avoid the risk-retention rules going in place after Dec. 24.
The rules will require CLO managers to retain a minimum 5% stake in the CLOs they sponsor in order to have “skin in the game” that regulators (enforcing a provision in Dodd-Frank) believe better aligns manager interests with those of investors. CLOs issued prior to the deadline are exempt from the standard, but concerns have been raised in the industry that refinancing a deal after the Dec. 24 enforcement date could trigger the requirement.
The CLO industry has vehemently opposed the measure due to the capital constraints it would impose on many CLO firms unable to meet the 5% threshold, which amounts to $25 million on a $500 million CLO. The regulations are cited as reasons for a diminished number of less-capitalized managers in the field, as well as consolidations of CLO manager firms.
(In Europe, a proposal before the European Parliament could be even more draconian in requiring a minimum 20% retention stake standard would be imposed on CLO managers across the pond. Many industry observers have considered the proposal unworkable and unlikely; a vote by parliament was scheduled for Wednesday on the measure, according to Moody’s).
Risk retention is not the sole driver of refinance/reset activity, though. The growing investor demand for CLOs is tightening spreads that buyers are willing to accept on CLO liabilities. Some deals with favorable spreads are also turning to refi’s because of looming step-up coupon rates that were baked into the original deals.
In Moody’s report, the agency noted that risk retention also played a factor in the introduction of new well-capitalized manager firms in the third quarter: TCI Capital Management and Park Avenue Institutions Advisors – a subsidiary of Guardian Life Insurance Co. of America – launched their first CLO deals into the market.
Consolidations also took place. Two existing CLO managers – NewStar Financial and TIAA Global Asset Management – made acquisitions of other CLO firms to expand their own platforms and launch deals in the third quarter.
If the risk-retention challenges weren’t enough last quarter, CLO managers were also fighting the tide against asset quality deterioration within their portfolios. The level of CLO assets of Moody’s-rated deals exposed to corporate leveraged loans with covenant-lite features, such as the lack of maintenance tests, surged to 75% from 68% from the second quarter.
The exposure to lower-rated speculative-grade companies also grew, with firms rated ‘B3’ or lower on Moody’s corporate rating scale comprising 24.7% of CLO assets, compared to 23.2% in the second quarter. However, exposure to defaults fell to 0.2% from 0.5%.