Perhaps not surprisingly, CLO managers last year found themselves dipping into the same pot of securities in order to ramp up their deals at a higher rate than in recent years, according to an analysis by JPMorgan Securities released last week.
The issuance of CLO deals has outpaced the availability of new collateral to back them, fueling increasing overlap between U.S. CLOs in recent years - but whether the concentration is good or bad depends on the quality of collateral or names being cherry picked, and on the competence of the CLO manager, according to JPMorgan.
The U.S. arbitrage CLO market, excluding middle market transactions, ballooned to nearly $50 billion in 2005 - doubling the roughly $25 billion in issuance posted the previous year. Anticipated growth within the leveraged loan credit default swap market would help mitigate the risk of too many deals chasing too few securities in the future. However, last year's herd behavior could cause difficulty for the vintage as the collateral ages, some say.
Roughly 29% of securities in 2005 were referenced in more than one CLO deal, compared with 22% for the 2002 vintage CLO, 27% for 2003 and 23% in 2004. On average last year across the three vintages, 25% of securities were referenced in more than one CLO deal - three percentage points higher than a year-and-a-half ago. JPMorgan's analysts came to the 25% average figure for 2005 through a $27 billion sample consisting of 41 U.S. arbitrage CLOs issued between 2002 and 2005. This is about 17% of the total par amount by dollar volume, as of February data. Middle market loans were excluded in all of the calculations, as were multiple deals from the same asset manager.
Collateral overlap
JPMorgan found that collateral overlapping between more than one CLO vintage has become increasingly common. The cause could be demand outstripping supply in the CLO space - a trend that might hold. "Should the trends of huge CLO growth and more moderate new issuer growth continue, overlap may be set to increase in the future," JPMorgan analysts wrote last week. But choosing a deal that has less overlap with others within the sector is still an option for investors. For example, within the sample of 2005 vintage deals analyzed by JPMorgan, CLO collateral overlapped with at least one other deal in the survey in concentrations ranging from as little as 14% to as much as 46%. But because only one deal per manager was accepted in the sample analyzed by JPMorgan, actual overlap is likely higher, assuming that managers sprinkled the same collateral throughout more than one deal.
Yet overlapping collateral may not be all that bad, as long as managers are familiar with that collateral. Earlier vintage structured finance CDO transactions, for example, that emphasized diversification and swooped up bonds managers were unfamiliar with - such as aircraft lease and manufactured housing loans - bombed when that collateral went south. "It is not clear that asset overlap between a manager's transactions is necessarily a bad thing, as the manager may have skills in a certain sector or in credit selection generally. Further, diversification is a benefit, but must be weighed against the quality of the managers one employs to obtain it," JPMorgan wrote.
Likewise, a number of CLO managers last year turned to the middle-market loan sector as they tried to ramp up deals amid a tight collateral spread environment. But while increasing liquidity to the middle-market CLO space may be inevitable given the level of demand - growth in this sector may be a double-edged sword. The middle-market CLO business has matured along with the influx of liquidity, with compressed prices and an improving quality of reporting and analysis. But some say problems arise when a more receptive secondary market sparks an erosion of underwriting standards and the entry of new, less experienced issuers onto the field. (ASR, 04/17/2006)
JPMorgan points out that it is not so much the volume of collateral overlapping between transactions, but the kind of collateral being spread around and the quality of manager handling each transaction. As investors in the senior portion of the CLO capital structure may not be paid enough to take the broad or systematic risk associated with a high name overlap, they should look to hold a variety of managers and vintages, JPMorgan wrote. The bank's analysis argued that investors in the lower parts of the capital structure have more reason to be worried about idiosyncratic or name risk - and they should carefully examine the types and concentrations of names within the deals before purchasing.
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