The current buoyancy underlying the U.S. CLO market can be attributed to a number of issuance friendly factors, not the least of which is significant interest from new buyers, market participants say.
Following the financial crisis, the principal investors in CLOs, most notably SIVs or structured investment vehicles, disappeared. As the market slowly and sporadically recovered during 2010 and 2011, deals were largely completed thanks to a small number of triple-A buyers and the capacity of managers, often affiliated with private equity shops, to bring the equity to deals.
But that appears to be changing, as more investors in both of these critical areas enter the market.
“One regulator on market size has been triple-A demand, but that is deeper today than a year ago,” said John Popp, head of the leveraged investments group at Credit Suisse Asset Management (CSAM). “There was much greater interest in the triple-A piece that we did in our most recent deal than we saw in all of last year. And we’re not the only ones that are seeing that.”
CSAM is managing one of a slew of deals completed in February and the first half of March. The $413 million Madison Park VII CLO, arranged by Bank of America Merrill Lynch, includes a $252.5 million triple-A tranche priced at Libor plus 142 basis points, the tightest the market has seen yet. The most senior tranches of other recent transactions have also printed in the Libor plus 140-150 basis point range, a good bit tighter than the 155-165 basis points pricings of the fall. And market participants expect spreads to continue to come in.
In all, volume in the first 10 weeks of the year reached $4.9 billion via 13 deals, according to analysts at Royal Bank of Scotland (RBS). (A $360.8 million CLO managed by Babson Capital, via Citigroup, has since printed, though it is a refinancing of an older deal). In fact, February marked the largest new issue volume since the financial crisis, surpassing November 2011, with seven deals totaling $2.54 billion.
Currently, market watchers put the number of deals in the pipeline at around eight to 10.
And increased demand, along with other positive forces, is playing a part in the surge in deal flow and the accompanying price contraction, market participants say.
“We attribute the tightening in the triple-A tranches to a variety of domestic and foreign accounts entering the CLO space over the past year. CLOs are more broadly syndicated than they were last year, and this is a sign of a maturating market and sustainable growth,” said Justin Pauley, an RBS analyst. “As an additional benefit to the market, some of these new investors are buyers in parts of the capital stack that have recently been challenging to place, such as triple-A and equity.”
In addition to these new buyers, a rally on the secondary market, which has made new issue levels relatively more attractive, and a decrease in volatility due to strong economic data make up the other principle factors helping to boost deal flow, RBS analysts note in a recent report.
It should also be noted that demand for these products, which sources say is coming largely from U.S. banks at the triple-A level and foreign buyers such as pension and hedge funds at the equity level, is not without good reason: CLO equity is offering returns in the area of 15% to 20%. And even though triple-A spreads are tightening, when you compare them to other structured products, such as credit card and auto securitizations, the returns are substantial. Three-year triple-A credit card tranches are now at Libor plus nine basis points, while triple-A autos are at 19 basis points over swaps, according to ABS analysts at Wells Fargo.
Still, despite new interest in both the triple-A and equity tranches of new CLOs, market participants agree that placing the equity can still be challenging. “I don’t know that there’s been a really broadly syndicated deal,” a CLO manager said.
As such, firms that can bring at least part of the equity themselves, most often through their affiliations with buyout shops, continue to have an easier time completing a deal, market participants say. And the mezzanine tranches of CLOs remain the weakest demand wise, though these pieces are much smaller than the triple-A slice, so unlikely to hold up a deal.
What could hold up a deal, or many deals, are economic forces outside of the CLO market—whether that be the European debt crisis boiling up again or China’s slowing growth—and the implementation of U.S. legislation that could negatively affect CLOs. For this reason, analysts such as Pauley and Dave Preston at Wells Fargo maintain their volume forecasts for the year at roughly $12 million to $14 million, more or less the same level as 2011. Others have predicted issuance could reach $25 million, a level many market participants call overly optimistic.
Much like last year, analysts expect this year’s issuance to be lumpy, with surges of volume like the one we’ve just seen, followed by pullbacks likely due to volatility caused by macro economic forces.
Market volatility makes it difficult to ramp CLOs because, while both the prices of CLOs and the underlying collateral fall, once conditions improve, loan prices generally recover much faster. And the bouncing around makes the arbitrage tricky—in other words, dealers can’t do a new deal if they can’t raise enough proceeds selling the liabilities to pay for the underlying assets.
For these reasons, RBS analysts believe the current rate of issuance is unsustainable. “Though we’d rather be wrong than right,” Pauley said.