If the leverage finance market has a Mickey Rourke - the actor who wrestled his way back on top - it would probably be the CLO manager. CLOs have experienced a comeback recently, mainly because secondary prices have improved since the first quarter. But market participants believe that CLOs are still on the ropes, and will be for the rest of the year.

"If we were to paint a broad brush stroke," JPMorgan Securities analysts said in a recent report, "the CLO market is in a 'positive feedback loop.'" The loop, they said, describes how technical and fundamental improvements are "feeding back" to investors looking for yield. "Although risks remain, it's hard to see this loop breaking anytime soon."

The most significant factor that has helped revive the CLO market has been the improvement in secondary loan prices. The average price of a loan in Markit's LCDX index - one market barometer - was 80 cents at the start of the year. The average price dipped down into the low 70s in the dead of winter but surged as the weather warmed. Last week, it was in the low 90s.

But what is surprising about the CLO comeback is that it happened as CLOs were hit by a wave of downgrades.

"On the back of improved loan prices, CLOs were, in May and June, able to combat the downgrades and defaults in the underlying portfolios," said Gene Phillips, a director at PF2 Securities Evaluations and author of The Corporate Loan and CLO Conundrum.

For 2003 through 2007 vintages, 10% to 18% of triple-A-rated tranches were downgraded between Jan. 1 and the end of June, according to JPMorgan. That's up from a range of 8% to 12% during the same period last year. Late last month, after announcing it had downgraded approximately 500 tranches of 93 U.S and European CLOs in the second quarter, Moody's Investors Service said the majority of top-rated CLO tranches were in danger of losing their triple-A rating. However, the number of downgrades in the second quarter was nothing compared to the havoc wreaked in the first, when the rating agency downgraded approximately 1,800 tranches. This illustrates that the pace of downgrades is slowing, sources said.

There is more evidence to show that CLO structures are improving. The percentage of assets with a rating between 'Ca' and 'Caa1' has dropped by more than 60% over the past two months, according to analysts at Wells Fargo. Roughly 15% of all CLOs are rated triple-C. The percentage of assets with a 'B3' rating has also fallen. As of July 20, 11.7% of CLO assets were rated 'B3', down from 13.3% in mid-April. "This is a welcome sign to CLO managers, who now may have more confidence that the triple-C buckets will not be quickly refilled," Wells Fargo analysts said.

And CLOs got another boost when resources became available to help make the market more transparent, according to Wells Fargo analysts. In June, Moody's launched a monthly newsletter called CLO Interest to better inform investors on credit issues involving CLOs and provide a month-to-month analysis of overcollateralization levels.

The CLO market even benefited from events that didn't happen. Late last year, when the economy worsened, there was chatter about rampant consolidation among CLO managers, sources said. The consolidation never happened. And in hind sight, that was probably a good thing for the market, because it would have resulted in more liquidations and significant layoffs.

"What's interesting is the big myth in the market that there was going to be consolidation mania," a New York-based banker said. "It turns out that a lot of the people, when they realized how much they had coming in from their fees, realized there wasn't much to sell. You couldn't just sell and go to the beach. But if [a manager] did find a way to sell, the buyer usually just wanted the assets and not the people, because no one needs two teams. However, no manager wants to put their team out of work, so if there's not enough money to spread around, managers are just saying 'screw it' and trying to take care of their people."

From a buyer's perspective, there has been little incentive to approach another firm. "There are few managers sniffing around out there," said a Boston-based investor. "We've got the infrastructure, and we could layer in a CLO. But are we going to pay somebody for a CLO that's only yielding a 25 basis point management fee? God no! Even if it was paying a full management fee, we would say, 'OK we'll take it over if you need us to.' But we wouldn't pay money for that."

CLO managers will continue to suffer from falling subordinated management fees - the fees they collect from subinvestment grade tranches, source said. These fees account for 50% to 60% of a manager's total fee pool. "Those fees have been cut off, and they're not going back on. I think with all the good news, CLOs are still going to be going through awful times because they're not receiving all of their management fees, so they're not able to pay all of their people," the New York-based banker said.

 

Going Up? Not So Fast

Now that the shockwaves from the initial credit crisis have subsided, market participants are wondering if CLOs can actually improve even more. One way managers have been improving their portfolios is by "building par," or picking good credits that could go up in value.

In May and June, the increase in loan prices helped the value and liquidity of triple-C buckets and allowed managers to sell assets they might have bought below 85 and use those gains to improve the results of their overcollateralization tests, sources said.

But CLO managers still face risks, including the possibility of another systematic event, such as a large bank failure, the JPMorgan analysts said. The chances of this, however, are low given how governments globally are looking to avoid a large scale systemic failure.

Other big risk factors include the lack of new issuance and the deterioration of underlying credit quality. These factors will abate once sentiment in the broader markets changes, sources said. And once it does, CLOs will look like an attractive opportunity from a relative value standpoint.

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