Corporate borrowers continue to take advantage of strong demand for loans to re-price existing debt, and this is putting a squeeze on some of the biggest buyers of loans—collateralized loan obligations.
CLOs issue bonds, most of which are triple-A rated, and use the proceeds to purchase below investment grade loans. This only makes sense when the interest rates on the debt CLOs issue are considerably lower than the interest payments they receive on the loans used as collateral.
But during the first quarter, interest rate spreads on loans contracted much more than spreads on CLO notes, making the arbitrage much less attractive.
Some of this tightening has been reversed, but even so, spreads on double-B and single-B loans finished the first quarter between 75 bps and 100 bps tighter than they were at the end of 2012, according to an April 12 report by Bank of America Merrill Lynch.
Spreads on CLO liabilities also tightened during the first quarter, but not by nearly as much: just 35 bps.
This has made it much harder for CLO managers to amass collateral for new deals. It’s not just spreads on new-issue loans that are tighter; as a result of the strong demand, a large portion of loans trading in the secondary market are trading above par, according to BofAML.
Companies are able to re-price loans thanks to strong demand from all quarters. In addition to CLOs, new exchange traded funds and mutual funds that invest in leveraged loans are coming online.
“Lower CLO asset spreads are the result of lower borrowing costs for companies,” Ryan Asato, a director at BofAML, said in an email to Leveraged Finance News. “To the extent borrowing costs decrease, copanies, to the extent possible, may take advantage of the lower rates through a refinancing or re-pricing.”
The problem isn’t just that so many loans are re-pricing; it is also that re-pricings account for the bulk of new issuance. There has been relatively little new debt issued to fund buyouts or mergers and acquisitions or other kinds of corporate growth.
Some $150 billion of loans syndicated to institutional investors were issued in the first quarter, but most of this activity, $113 billion, came from the re-pricing of existing loans. After taking into account other kinds of refinancing and debt retirement, the amount of loans outstanding rose by just $11 billion, according to BofAML.
By comparison, new CLOs, mutual funds and ETFs raised some $41 billion of new money to put to work in loans during the same period.
This doesn’t represent the net amount of money that entering the loan market in the first quarter, since many CLOs that were issued before the financial crisis are have exited their reinvestment periods and are being would down. There are also a number of private funds and large investors putting money to work in leveraged loans. But the figures convey a sense of the current imbalance between supply and demand.
“Loan re-pricings have added pressure to the CLO market, as it has caused the arbitrage to compress and has made ramping deals more difficult,” Asato said in the email. “Lower spreads may also end up impacting equity returns due to excess spread compression.”
Another factor contributing to re-pricing volume: the upfront fees for these transactions have dropped substantially, according to BofAML.
In its report, the investment bank noted that the $113 billion of loans that re-priced in the first quarter overwhelmingly exceeded the $72 billion of re-pricings done in all of 2012. It also represents more than 40% of the $350 billion of loan re-pricing BofAML had forecast for all of 2013.
Analysts predict that re-pricing volumes should start to come down in the second quarter, although they will still remain somewhat high given that many loans issued last year will soon be exiting their non-callable periods — $32 billion for this quarter and $53 billion in the third quarter of 2013.
In the report, Asato said that it is still too early to determine how loan re-pricings might have affected CLOs that closed in the fourth quarter of 2012 and the first quarter of 2013. “There may be some recently priced CLOs that are still purchasing collateral for their deals,” he said.
“In addition, there is a lag between when the deal closes and when the final portfolio is disclosed in trustee reports. The impact will be dependent on when the collateral was purchased and the spread level. Those also need to be compared against collateral assumptions used in marketing, pricing, and evaluating the deal.”
Not all tranches of bonds issued by CLOs are likely to be affected equally by loan re-pricings, according to BofAML. For the senior and mezzanine liabilities, re-pricings should be modestly positive, to the extent that lowering interest payments on loans reduces the debt service burden on borrowers, making it them less likely to default.
Borrowers re-pricing loans in the first quarter reduced spreads on this debt by an average of 83 bps; they also reduced Libor floors on this debt by an average of 24 bps, reducing all-in yields by 107 bps, on average, according to BofAML.
The most subordinated tranches of CLOs, also known as the equity, don’t make out so well. BofAML reckons that the compression of the “excess spread” between yields on CLO assets and liabilities has caused its “idealized” equity return to drop from 15-16% at the start of 2013 to 14% at the end of the first quarter.
CLOs have been taking a page out of the loan market’s playbook. A number of newer deals allow for the notes they issue to be re-priced. In these deals, CLO indentures typically allow a majority of the equity holders to direct a refinancing of any class of notes after the non-call period, which is typically two years.
CLO re-pricings differ from refinancings. In a refinancing, the new notes’ terms are negotiated between the CLO manager and the buyers providing the refinancing. By contrast, the only change in a re-pricing is to the re-priced class or classes is to the spread over Libor, according to a recent client alert from the law firm Milbank.
“It’s kind of like a refi-lite where you only need to take out non-consenting noteholders at par and lower spreads over Libor for the consenting investors in a tranche. Essentially all that’s required is a supplemental indenture,” Deborah Festa, a partner at Milbank said.
Festa said that the CLO market will likely see more re-pricings in a couple of years when the rash of deals printed in 2012 exit their non-call periods.
“Re-pricings provide flexibility and are not time-consuming. It can be a win-win for both the equity and the debt investors,” she said.
“It gives equity flexibility to lower the deal’s financing cost, and on the debt investors’ side, they don’t need to redeploy capital into a new transaction when they would otherwise be repaid at par in a refinancing and presumably search for another investment.”
She added, “It’s a helpful tool to respond to a changing market.”