The outsized sway of the collateralized loan obligation market’s triple-A investor is no secret—simple math will tell you that the relatively small group of investors buying up what is generally the largest tranche of a CLO transaction will have more power to dictate terms than would be the case if demand for triple-As were broader.
Pet demands vary from investor to investor; market participants say, maybe the buyer likes longer call protection, or has a lower tolerance for covenant-lite loans. One recent example that has popped up in a number of CLO transactions over the last several months is a second triple-A tranche priced with a step-up coupon.
According to market participants, this tranche has been customized for one particular triple-A buyer, which is trying to build a shorter duration portfolio. The step-up tranche typically can be refinanced at 1.5 years.
“The idea is that after 18 months the coupon steps up, and their hope is that the manager can refinance that tranche with another investor at a lower spread,” said a banker at one of the market’s lead CLO arrangers. “It provides incentive to make that bond shorter.”
A recent example of a CLO with the step-up feature is a $609 million deal priced by Wells Fargo in November for Apollo Credit Management. The deal included a $270 million triple-A tranche priced at Libor plus 145 bps and a second $120 million triple-A tranche with an initial spread of Libor plus 110 bps, according to a pre-sale report by Fitch Ratings.
According to Fitch, the initial weighted average cost of funding for the second tranche is 1.86%; in July 2015 that increases to 1.98% due to the first spread step up; it then increases again in July 2016 to 2.04% after the second step up.
Likewise, a $415 million CLO priced in October by Wells Fargo for the Carlyle Group features similar pricing.
Carlyle’s Global Market Strategies CLO 2013-4, has three classes rated AAA’ by Moody’s Investors Service; the $1.2 million class X notes were marketed at Libor plus 90 bps; the $122 million class A-1 notes were marketed at Libor plus 147 bps, and the $130 million class A-2 notes have a step-up coupon: they yield Libor plus 110 bps for the first 18 months, Libor plus 160 bps for the next 12 months and Libor plus 190 bps thereafter, according to Moody’s.
Additionally, American Capital CLO Management priced a $414 million CLO with a step-up coupon via Citigroup at the end of August. Again, the spread begins at Libor plus 110 bps, then steps up to Libor plus 160 bps at 1.5 years, and again to Libor plus 190 bps at 2.5 years.
CLO arrangers and managers have long bemoaned the small pool of triple-A investors, which has remained insufficient to meet the strong demand for new issue CLOs. More than 50 new triple-A investors have entered the market since 2011, according to some sources, but only a handful of them can take down majority positions of triple-A CLO notes.
The positive way of looking at the situation is this:
“I feel that our job is to take feedback from investors on what they want and then find ways to create that product,” said a second banker at another leading CLO arranger. “It may or may not be as obvious as a step-up coupon. There are other investors who might like to buy things at a bigger discount or they like a longer call protection than is normally there in a deal. What we try and do is find situations where equity investors and mezzanine investors are comfortable with that.”
He added, “I feel that that’s an ongoing exercise where people in our seats are getting feedback from investors on what they want and are creating product to cater to that.”
That said, with less demand and widening spreads (CLO triple-A spreads were as low as Libor plus 110 bps in the first half of the year, and are now right around Libor plus 145 bps) triple-A investors wield even more power at the negotiating table.
Part of the reason behind this trend is the FDIC assessment charge, which caused some banks (the largest triple-A investors) to pull-back from the market. The FDIC changed its definitions of certain higher-risk assets in February 2011, when it revamped its system for calculating the deposit insurance premiums banks must pay the agency. The new definitions apply to loans and CLOs issued on or after April 1 of this year. Those issued before that date are grandfathered.
Generally speaking, all CLO tranches are given equal risk weighting, regardless of their credit ratings. That means banks, which were previously big buyers of triple-As, now have an incentive to invest some of their CLO allocations a little further down the capital stack.
“If the depth of the market for triple-As were greater, if there were enough buyers to fully syndicate deals on a competitive basis and have oversubscription, then absolutely (they would have less power),” a CLO manager said. “But right now you got a handful of people who can write really big tickets and a bunch of other people who can write smaller tickets. If you go to the guys that can write big tickets you’re going to have to swallow their terms. The market’s just not deep enough to drive competitiveness.”
This lack of depth isn’t hurting volumes, however. Barclays expects 2014 issuance to be similar to this year’s total, in the range of $75 billion to $80 billion.