Spreads are widening on CLO AAA notes for the first time in nearly a year, as an April bulge in new-deal and reset volume saturated the market supply of collateralized loan obligations.
According to Thomson Reuters LPC, AAA spreads on new primary issuance widened to 103 basis points over Libor from an average discount margin of 98.1 basis points above Libor. It was the first month-to-month widening in senior-note CLO spreads in nearly a year, since May 2017.
The widening spreads occurred in what was the busiest month of the year for combined volume of new-issue CLOs and reset-refi transactions. Primary CLO deals totaled $10.9 billion (nearly matching March’s $11 billion total) across 18 deals, while refinancings, resets and reissues totaled $19 billion, according to LPC. The $15.3 billion volume for resets bests the January all-time market record when $11.3 billion worth of deals had maturities and reinvestment periods extended.
Although the widening reported by LPC measured only new deal pricing, markets participants say the glut of refinancings, resets and reissues had a secondary impact on primary market. “The weakness that was driven by refi and reset supply spilled in to primary issuance and we saw a widening of new issue liabilities as well,” said Gretchen Lam, a senior portfolio manager for Octagon Credit Investors.
In February and March, 15 new-issue CLOs priced inside 100 basis points of Libor. In April, that total fell to two: Barings CLO 2018-2 and Chenango Park CLO. Both deals priced before April 11.
Ten subsequent deals priced now lower than 101 basis points, including three last week: Neuberger Berman Loan Advisors 28, Redding Ridge 4 and GLM US CLO 2018-1.
The new spread-widening trend is also occurring down the capital stack. April's movement increased BBB-level notes pricing to more than 300 basis points wide of Libor, an increase of 60 points wider than near the end of 2017, according to Deutsche Bank research.
Much of the April volume was driven, say observers, by February's court-ordered repeal of risk-retention requirements on CLOs which became finalized last month in the absence of an appeal by federal regulators.
Lam also pointed out that April’s heavy refi/reset volume was also influenced by the quarterly payment calendar for CLO notes. Managers performing refis and resets of CLOs must often perform the transaction on a scheduled quarterly payment date – which for most deals is January, April, July and October. “Many of these deals were required to close by their April payment dates and so had little flexibility in timing. As a result, many became price takers when pricing liabilities,” she said.
Despite the impact of supply and demand that is inviting investor pushback, many believe the widening will only be a short-lived reversal with a pipeline of deals that may begin to slow.
JPMorgan, in a research report last month, said it considers the spread-widening trend a temporary blip with CLO supply slowing down in the near-term. "Our sense is that spreads will start to stabilize sooner rather than later," based in part of slower CLO issuance from managers that are being squeezed on cost of funds by rising rates paid to investors while receiving less cash flow from tighter spreads on underlying loan collateral.
That reduced cash flow involves record levels of 2017 refinancings of leveraged loans, as well as new Libor hedging strategies that corporate borrowers are adopting, reported JPMorgan. Taking advantage of the widening spreads in one-month and three-month Libor benchmarks, JPMorgan described how borrowers are toggling to the lower one-month lower rate against the same spread to reduce their payments. Up to 75% of corporate loans in CLO collateral portfolios paid on three-month Libor in early 2016, according to JPMorgan; today, that has fallen to 41%.
This strategy erodes excess cash flow to many CLOs that are tied to three-month Libor-rate payments on their tranches, and eroding the spread available to the subordinate equity tranches of CLOs.
The slowdown in the supply has already "firmed" the market up, said Lam, who said that triple-A spreads "have moved in marginally" in the past week, "and you're definitely seeing the bottom of the stack move in."
While market governors against a continued CLO oversupply are in place, a large portion of refi-eligible CLOs is still on the horizon. According to Deutsche Bank, two-thirds of 2015-2016 deals have been reset, but another $80 billion in deals will be eligible through the end of 2018.
Even resets of pre-2015 CLOs exiting could be sizable. Over $25 billion worth of those deals have already been reset, but more than $80 billion more have reinvestment periods ending in 2018, Deutsche reported.
Most of these deals have original price levels, too, for which a refinancing or resetting makes sense in the existing market - or even if CLOs were to widen back into the 120 range, said Lam.
According to LPC, the year-to-date total for new-issue CLOs is $42.8 billion, which is 55% ahead of the 2017 pace and has built total volume of outstanding U.S. CLOs to $526 billion.
For European CLOS, new-issue volume was flat at €2.5 billion, with YTD volume now at €8.7 billion – nearly double last year’s pace of €4.4 billion at the end of April 2017.
Leveraged loan issuance remains down at 30% on the year at $362 million, following April's activity that was driven by $65.3 billion in refinancings and $27.7 billion in new-loan issuance.
In the first quarter, leveraged loan refinancings topped the level of new-loan activity, $181.9 billion to $87.4 billion.