Spreads on collateralized loan obligations are unusually wide given currently lower default rates and improved recoveries, suggesting now might be a good opportunity to purchase CLO paper.
However, with CLO spreads lagging, new deals could be increasingly uneconomical, rendering the equity a hard sell. Unless the trend reverses next year, new CLO issuance might be dampened.
A stronger credit market should fundamentally serve to increase demand for CLOs and consequently tighten spreads on those notes, sources said. Instead, the spreads on some of those notes are actually higher than last year, when the credit health of the underlying collateral was significantly worse. In research, Merrill Lynch recently noted that triple-A notes are 12 to 13 basis points wider than the tightest periods in 2002.
"We see value in new-issue CLO paper, particularly at the senior level," wrote Dan Castro, head of structure finance research at Merrill.
Technical factors may be pushing spreads wider temporarily, analysts noted. Investor attention may be focused on other, more liquid areas of the market.
"A lot of people at the end of the year are looking for liquidity, and CDOs in general are not very liquid products," one bank researcher said, adding that slowing investor demand as the holidays approach may also be pushing spreads wider. "We could see some tightening in the New Year, when the market starts up again and investors have new [investment] limits."
Anthony Thompson, an ABS analyst at Deutsche Bank Securities, agreed that any spread widening now was likely short-term. "It's just technical noise and year-end selling," Thompson said.
Banc of America Securities analyst Lang Gibson noted that CLO spreads have historically lagged collateral spreads. "It just takes a while for CDO investors to realize that if spreads are coming in on the collateral, they shouldn't be compensated as much," he said.
A drop in CLO issuance would likely give the sector some scarcity value, driving spreads in. Otherwise, new-issue CLOs will be a tough sell, especially at the equity level, if excess spread is not at attractive levels.
"There [won't] be adequate economics for equity holders to justify buying these deals," Gibson said, adding that if note spreads don't tighten or collateral spreads widen, "then there's going to be substantially less issuance."
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