The $1.119 trillion market for leveraged loans has never been larger in the post-crisis era.
But secondary-market trading has also perhaps never been as trying for managers of collateralized loan obligations, due to a dearth of short-dated loan assets within that large supply.
According to a new report from Moody’s Investors Service, the lack of loans with near-term maturities (through 2021) has "constrained" trading by collateralized loan obligation managers, who usually swap in short-term loans to relieve stress on their portfolios' weighted average life tests.
The WAL test calculates whether a deal is on course to pay off its principal debt notes, usually eight to nine years after issuance and reduced each year until the CLO is paid off, or refinances.
“As companies have refinanced debt, the resulting dearth of shorter-dated loans has constrained trading among certain CLOs, particularly those issued between 2013 and 2015 and either nearing the end of their reinvestment periods or in their post-reinvestment periods,” the report stated.
Moody’s noted that in September, the average number of years to maturity among loans tracked by IHS Markit’s U.S.-dollar leveraged loans index reached 5.08 years – up from 4.45 years in 2016.
The primary factor in the maturity lengthening is the fast pace of new issuance ($1 trillion this year through October) that add to the aggregate maturity wall, plus a 2017 refinancing wave that reduced the universe of loans with maturities in 2018-2021 to $323 million at the end of 2017 – down from $383 million in late 2016.
With fewer options for trading, 68 reinvesting CLOs and 56 amortizing CLOs issued between 2013-2015 were failing their WAL tests as of September.
Managers falling short of the WAL covenants are usually only permitted to trade assets so long as the WAL figure is reduced. They must also ensure new assets also don’t compress the weighted average spread below minimum levels – or that the average ratings factor of the loan pools don’t deteriorate as well.
Not all of the impact of the short-dated loan shortage is a negative. At least seven CLO managers have made the “unusual step” of accelerating paydowns on CLO notes during reinvestment periods this year, according to Moody's.
Moody’s states that "if current conditions persists," this trend might pick up. CLO equity holders, often controlling ownership stakes in deals, would be less likely to leave deals outstanding if managers were constrained from making trades. Managers' trades can offset the decline in excess spreads "that accompanies [equity's] rising funding costs as senior notes in the deals amortize."
Some managers have taken a strategy on the short-term loan squeeze that Moody's considers detrimental to a portfolio’s credit standing: holding additional cash. Keeping more cash on hand instead of distributing the funds or buying assets can result in negative carry and reduce excess interest available to noteholders, Moody’s noted.
In July 2016, 4.3% of outstanding 2013-vintage CLOs (three years after issuance) had cash holdings of over 5%. That figure rose to 12.9% of comparable 2014-vintage deals in July 2017. The figure for 2015 CLOs was 7.9% this year.
Managers are also taking on more risk by expanding the types of loans they purchase to deal with WAL test failings. Those include Term Loan ‘A’s’ that are shorter duration with lower spreads that could impact WAS tests.
In addition, "managers say the limited short-dated investment options can push them to retain loans they would otherwise sell,” the report stated.
