With heightened risk aversion sending spreads in the CDO market to gaping widths, the CLO market has seemed to remain intact. However, spillover from the subprime turmoil and hedge funds' recent attempts to divest their loan positions will push CLO liability spreads wider, market participants predict.
"Without a doubt, spreads will get wider," said a CLO manager, noting that liability spreads have progressively been pushed wider since the initial blowup in subprime and ABS in early spring. Previously, these deals were printed at close to market spreads and sold at a discount off the dealer's desk. But now, CDO experts are expecting spreads to be printing wider right off the bat.
In fact, the market has already started to see spreads come out. For instance, single-A' CLOs are at least 120 to 140 basis points widening from 68 to 70 basis points at the end of 2006 and the beginning of 2007, Alexander Rekeda, head of U.S. structured credit at Mizuho Securities, said last Tuesday. While it still depends on the quality of the deal, spreads are already at least two times wider, he added.
However, the full impact of the liability widening is anyone's guess, market participants said. "I am not sure many deals have priced this month. It is an area of price discovery, without a doubt, and it is ugly," the CLO manager said. Much of the buzz has stayed behind the scenes and not hit the public domain because not many deals have priced lately and price discovery has been a bit difficult. However, at a minimum, triple-B tranches could push into the 300 to 400 basis point range, he predicted.
At the same time, the recent blowup in the loan market has only exacerbated the issue, with deals facing trouble gaining investor interest. This is partially a result of hedge funds selling their loan positions. Though it is unclear whether or not investors believe these sales are to take advantage of opportunities in other markets or to cover the funds' losses.
The hefty loan pipeline and heightened risk aversion because of subprime troubles also play into the expectation for wider spreads. "Clearly, a big chunk of the liability widening is really coming from what is going on with subprime, and [investors] are trying to weather the storm by not buying anything," Rekeda said.
A research report from JPMorgan Securities said that although CLO and structured finance CDO credit fundamentals were independent from ABS CDOs, the bank expected CLO spreads to soften throughout the summer as a result of the headline noise as well as supply overhang. "In CLO space, investors are holding back, knowing dealers have large inventories and feeling cash loan and CLO spreads have downside risk remaining," JPMorgan said. "Investors are still grappling with the implications of subprime turmoil - risk to monolines, dealers, and hedge funds - and unwilling to step in until there is more clarity."
However, the market currently has about $220 billion of leveraged loan supply, which means these leveraged loans will be hitting the market no matter what, Rekeda said. CLOs are buyers of 75% of the leveraged loan pipeline right now. "Clearly, the leveraged loan market is very dependent on the CLO market and, from that perspective, as there is more and more supply coming into the market, the spreads will widen, and it will allow CLOs to widen their liabilities without losing excess spread," he said.
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