To paraphrase the late crooner Frank Sinatra, Fitch Ratings expects 2005 will be "a very good year" for middle-market CLO issuance, as the agency is gearing up to rate more transactions in the relatively young asset class. Fitch warned, however, that anyone thinking of entering middle-market CLO land should make sure to bring the right tools for the job, as the asset class requires a different type of analysis than many asset managers and investors may be used to.
Alla Zaydman, analyst with Fitch, said she expects 2005 middle market loan issuance to equal or exceed last year's $168 billion, which was a $60 billion increase from the year before. "There is a large amount of issuance right now, and coupled with investor demand, we definitely think it will be a robust year," said Zaydman. "We're probably going to see more innovative structures in 2005. Investors have gotten more comfortable with this asset class over the past four years and there is good demand for this paper," Zaydman added.
Part of what makes the middle-market sector so attractive is the higher yield the loans typically offer. Given the fact that ABS spreads are as tight as they have been since the late-90s, investors are looking for yield anywhere they can find it, and that means turning toward middle-market loans. "Middle market looks attractive right now," said Zaydman. The problem is, the sector may become too attractive and draw in participants who do not know what they are getting into.
"It is necessary to have quite a different skill set to invest in the middle-market [loan] market," said Zaydman. Since middle-market loans are made to private companies with less than $100 million borrowing capacity, the loans must be monitored much more closely than loans to larger, public companies. The smaller companies have limited financial flexibility and are more susceptible to earnings downturns. "[You] have to have an asset manager that is very involved in monitoring [the loans]," said Zaydman. Asset managers of high-yield and other types of CLOs also like middle-market loans because the higher yield associated with the loans will bring up the weighted average spread of their deals, and the same caution should apply.
Fitch rates middle-market loans with a combination of the Algo Credit Rating System model as well as shadow ratings. "We're going to be very diligent in our ratings of the asset managers and the obligors themselves," said Zaydman.
Though the sector is experiencing a rapid growth period, Zaydman downplayed the suggestion that a bubble scenario could be in the wings. "While leverage is creeping up and coverage is getting thinner, I don't know if we're at that point yet," she said.
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