Prior to the recent dark age of credit, CLOs were kings in the land of the leveraged loan, a seat of power that diminished as the recession wore on and the loans in their fiefdoms lost value, causing a medieval-like bleeding of cash. But now sources say CLO cash is back, and the funds may once again be influencing the primary loan market.
“Many of the CLOs that were issued prior to 2008 have excess capacity,” said Tim Conway, chief executive officer at New Star Financial. “The combination of that capacity and light new issue volume have resulted in a tightening of spreads. In the near term, loan mangers will continue to be faced with excess capacity as the loans they manage amortize and refinance. However, much of that capacity will dissipate over the next few years as the reinvestment periods in those vehicles expire.”
The average spread on the Standard and Poor’s/Loan Syndications and Trading Association Leveraged Loan 100 Index this week hovered around Libor plus 508 basis points. At the start of the month, the average spread was at Libor plus 557.6 basis points, down from Libor plus 1,000.3 basis points six months ago, and way down from a whopping Libor plus 2000 basis points this time last year.
“We’re hearing that a lot of CLOs are sitting on 5% cash balances, which is the highest they’ve seen in well over 12 months,” a New York-based banker said. “[CLOs] are for the first time in a long time preferring to deploy cash in the primary market. Conditions have improved, with deals having lower leverage, more equity, Libor floors and more restrictive credit agreements. So, if there are new deals, CLOs will prefer to go there?”
CLOs, like other investors, are moving away from the secondary loan market because most of the yielding syndicated loans have been, as sources said, picked over.
The Quicker Picker Upper
Barclays Capital estimates that CLOs will be able absorb $40 billion to $50 billion in new loans in 2010. CLOs will be able to do this, sources say, because so much cash is coming from refinancings — mainly from high yield bonds taking out maturing loans — and from amortization payments.
“People continue to underestimate how much cash CLOs have,” a New York-based CLO manager said. “All this money is coming from high yield repayments, which is continuing to put cash in pockets of CLOs. My managers are getting cash in every day and wondering what to do with it. There’s nothing to buy.”
To illustrate just how thirsty CLOs are, as of last week the funds made up 46% of the institutional loan market, according to S&P Leveraged Commentary and Data. At the beginning of December, they only made up 31%.
However, not everyone is convinced that reinvestments will make a huge impact. “I am skeptical that simply recycling sporadic payoff dollars into new loans will move the needle very much,” a Chicago-based investor said. “At the margin, this may help the loan market a little, but I doubt it will matter much.”
It is no coincidence that issuance on the primary loan calendar picked up right around the time some CLOs started feeling flush. Issuance in the fourth quarter of 2009 was just a few billion shy of equaling the total amount of new issues in the first three quarters combined.
But still, some market participants don’t think the supply has been enough to soak up the cash that CLOs have on hand. “I’d say that most accounts would most likely be happy to spend money on the primary if it would actually show itself,” said a CLO portfolio manager at a large investment firm. “We just need that true new issue market to materialize and when it does, in that 5% to 7% yield range, CLOs will totally eat it up.”
A Canadian-based investor added, “I hear that most large lead banks have large high yield pipelines—much larger than their loan pipelines. That says to me that the pay downs will continue and that secondary technical’s should remain strong. The demand for reasonable yielding paper far exceeds the current and near-term anticipated supply.”
There are, however, those CLOs that still have problems passing their overcollateralization tests, and to help correct that, those managers are still looking for opportunities on the secondary to help build par.
However, for most CLO managers, secondary loans represent concentration issues — meaning that they don’t want overpopulate their portfolio with a particular asset or deal structure.
Return of the King?
All that said, market participants doubt CLOs will regain their crown as the leveraged loan market’s largest investor anytime soon. In 2001, CLOs made up more than 70% of the institutional loan investor base. From 2003 to 2006, CLOs made up 60% of the investor base, but by mid-2009, that number had dropped to 36%.
Still, market participants are confident CLOs will make an impact—even if it is less pronounced than it has been historically.
And some do believe the loan market will see a rise in the number of new CLOs. According to a recent JPMorgan survey, which poled 140 of the bank’s clients, 46% said new CLOs will begin to emerge in late 2010 or 2011; 40% said new CLOs will return in the first half of this year; and only 13% said that there will be no new CLOs in the foreseeable future.
