As any entrepreneur, boss or parent can attest, the key to avoiding disappointment is managing expectations. Got a B student at home? Expect a C, and when he walks in the door with an A, voila! Happy days!
This philosophy worked well for CLO market watchers in 2011, a year when volume landed comfortably within the typical analyst forecast of $10 billion to $15 billion—just over $12 billion in the end — despite a roller coaster ride of a year that saw issuance crank up early on, only to sputter in March, regain steam heading into the summer, then plummet again in August. As one CLO manager put it, “We were pretty happy that, despite the volatility in Europe, deals got done at all. It worked out better than we thought it would in September.”
As such, analysts have raised their expectations for 2012 issuance, but only slightly, with $12 billion marking the low end and optimistic projections ranging as high as $20 billion.
Indeed, CLO underwriters already have potential deals up their sleeves, market participants say. “CLOs continue to enter our ratings pipeline at a robust rate,” analysts for Moody’s Investors Service wrote in their recently published report, U.S. and European CLOs: 2012 Outlook. Yvonne Fu, a managing director in the ratings agency’s structured group, put the number of CLOs currently in the Moody’s pipeline a bit more precisely at six to eight.
This cautious optimism does not extend across the Atlantic, however—collateralized loan obligations will rollout almost exclusively in the U.S., market participants say, as little hope exists for any action in Europe. To be sure, the continuing economic crisis in Europe is largely what keeps market expectations in the U.S. from climbing further.
Fear the Macro Wave
“The biggest challenge is the macroeconomic environment. That has a lot of potential to weigh on risky asset prices, which it has. And that has a way of making investors more sensitive to risky asset investments, and it contributes to spread volatility,” said Rishad Ahluwalia, global head of CDO research at JPMorgan. “Our base case is a recession in Europe. The question is: How deep of a recession and how much will it impact the U.S.?”
To understand the challenge of pushing issuance significantly higher than the 2011 total, think of a bank structuring a CLO like a juggler attempting to keep all of his balls in the air. Investors in the higher-rated tranches, who get paid first, want as strong a return as possible, but the spread on the triple-A tranche, which typically makes up 70% of the structure, has to be tight enough to attract equity investors (unless the manager holds onto the equity), as any excess return rolls down hill to the mezzanine tranches and finally the equity holders.
“In pricing a new CLO, you’re trying to get all of the moving parts to fit together,” said Dave Preston, a CLO analyst with Wells Fargo Securities. “You have to get the triple-As tight enough to make the equity work. The tighter the triple-A is, the higher the equity returns. It’s a balancing act.”
The last CLOs of 2011 priced with triple-A tranches in the Libor plus 150-155 bps range, not the widest of the year, but not tight enough to spur a boom in issuance. By way of comparison, many CLOs from 2006 and 2007 priced with triple-A spreads at Libor plus 25 bps. So say loans are yielding Libor plus 400 on average, and your cost of funds is 50 bps, plus fees, anything after that goes to the equity.
“Any type of volatility that pushes loan spreads out is really good for CLO equity,” Preston said.
The balancing act that characterizes CLO origination will take center stage in the market in 2012, sources say.
“Assuming that the global macroeconomic environment calms down, the market will shift to finding new buyers for triple-A tranches as it tries to issue more deals, said Matt Natcharian, managing director and head of structured credit at Babson Capital Management. “If the market doesn’t attract more buyers, the spreads won’t tighten much, and it will be difficult to increase new issuance volume significantly. I think that’s going to be one of the biggest challenges.”
Most analysts do see spreads coming in somewhat, but not a lot, especially not early on in the year. “I expect, at best, a very modest tightening, perhaps five to 10 bps. I certainly don’t see significant tightening happening in the next few months, there’s too much uncertainty,” JPMorgan’s Ahluwalia said.
Still, few worries exist about market fundamentals or the underlying collateral in CLOs, which has performed well. Remember those 2006 or 2007 vintage deals? If you can get your hands on equity from deals priced in those two years on the secondary market, you can expect cash-on-cash returns, or the last 12 month’s payments divided by the equity notional amount, to continue in the area of 20%, Wells Fargo’s Preston and his colleagues wrote in their recently published CLO 2012 Market Outlook.
Even with new deals, where the triple-A tranches have priced much wider than in the boom years, which pushes the equity returns down, investors have shown strong interest in CLO equity, market participants say.
“The equity demand has been very diffuse,” John Popp, head of the leveraged investments group at Credit Suisse Asset Management. “There is a consistent presence from certain types of players, pre-crisis investors, who continue to invest. Then you’ve got a lot of new participants who’ve come in and taken a look. The thin part of the capital structure remains in the mezzanine, double-B through single-A in particular. I think there are more individual participants that are looking at the equity than there are looking at the mezzanine tranches of these deals.”
Meanwhile, CLO structures are expected to remain strong in 2012. In their recent report, Moody’s analysts note that the structures arranged in 2011 included features that are credit positive for CLO noteholders: increased subordination, especially for senior-most tranches; tighter eligibility constraints on collateral; shorter portfolio average lives and shorter reinvestment periods; and documentation with enhanced noteholder protection.
The Beginning of the End
The large number of CLOs due to exit their reinvestment periods over the next few years will clearly be an issue for the loan market over the next few years (see LFN Oct. 31, 2011, page 1), as will increased regulation (see LFN Nov. 12, 2011, page 1) . Still, both are expected to have more of an impact down the road, as a larger portion of CLOs come to the end of their reinvestment periods and regulations begin to go into effect.
As we kick off 2012, roughly 70% of U.S. CLOs, or $208 billion, remain in their reinvestment periods, according to JPMorgan analysts. The problem arises, however, as 90% exit reinvestment over the next three years.
Most CLOs do have some flexibility for continuing to invest after their reinvestment period ends. Still, with new issuance nowhere near filling the gap left by retiring CLOs, the leveraged loan market buyer base is certain to shift away from the CLO manager to other types of investors.
Indeed, if a recent calculation by Standard & Poor’s Leveraged Commentary & Data is any indication, relative value buyers could replace CLOs in the majority. In the third quarter of 2011, they bought up 56% of the leveraged loans issued on the primary market; while CLO managers bought just 24%.