In the Chinese Zodiac, 2011 is the year of the rabbit. But in leveraged finance, 2011 may be the year of the CLO, with this investment vehicle bringing more deals to the leveraged loan market.

Analysts at Wells Fargo and JPMorgan Securities projected CLO issuance will reach between $10 billion and $15 billion in 2011, while analysts at Barclays Capital said that number could be as high as $20 billion. That is more than double the $5 billion worth of new CLOs arranged in 2010.

Moreover, the analysts predict the volume will double in 2012, reaching between $25 billion and $30 billion. While those numbers may not be as lofty as the $90 billion reached in 2007 and the roughly $74 billion in 2006, more CLOs means these investment vehicles will have more buying power, which will in turn fuel the primary loan market.

The new CLOs that do show up to the party in 2011 will be dressed more simply, according to market analysts. “We expect generally simpler and lower leverage structures, with greater focus on underlying loan quality given the impending securitization retention rules,” Barclays analysts said in a recent report. “We also question whether some deals will exclude structured credit buckets to avoid higher re-securitization risk weights.”

If market analysts talking about how new CLOs will be simpler with less leverage sounds familiar that’s because it is. Most market observers at the start of 2010 were saying the same thing.

However, according to Dave Preston, a CLO analyst at Wells Fargo, the opposite was true — the CLO market in 2010 had fewer investors involved in each transaction, which meant that each investor had more say and could push for customized features.

This year, though, the CLO market needs simpler structures to entice new or returning, but less experienced, buyers.

“We believe that 2011 will see issuance of less leveraged (in the 6x to 8x range) deals, but with a broader investor base,” Preston wrote in a recent report. “The primary CLO investor universe has certainly shrunk since 2006, but we project that this world will expand in 2011 and 2012.

In addition, many legacy CLOs are entering their reinvestment period, and this could stoke the investment vehicle’s buying power.

According to Standard & Poor’s, CLO repayments will total $127 billion in 2011. While it’s hard to predict where that money will go, market participants say that CLOs will be keen on the primary market because new loans come with added bonuses, such as Libor floors. Morgan Stanley analysts noted in a recent report that Libor floors were “among the most significant loan market developments contributing to the performance of U.S. CLO equity tranches.”

While some legacy CLOs will remain active, using repayments to boost their portfolio, others may be looking for an exit, market analysts say. And that could lead to a round of consolidation among CLO managers.

The optimism in CLOs also stems from market fundamentals that have been improving over the past year. The loan default rate has come down to roughly 2.25% from just below 10% at the start of 2010, according to Wells Fargo.

“In our opinion, CLOs have proved their mettle and their worth over the past three years,” Wells Fargo’s Preston said. “The lesson of 2009 and 2010 is that the CLO structure performed as designed. After overcollateralization levels plummeted, due primarily to large-scale collateral downgrades to triple-C [tranches] combined with an unprecedented loan market sell-off, CLO curing mechanisms have worked.”

Another encouraging sign: Overcollateralization tests, which CLO managers use to keep the mix of debt in their portfolios in check, improved during 2010. Barclays analysts estimated that 8% of U.S. CLOs were failing their overcollateralization test by the end of 2010, down from 35% at the beginning of the year.

“These trends look set to continue through 2011,” the Barclays analysts wrote. “We anticipate a low loan-default rate [in 2011] as banks amend and extend, the low rate environment keeps funding costs down and the loan maturity mountain remains a few years away.”

Some market participants aren’t as optimistic. They said CLOs won’t have significant buying power in 2011 because the arbitrage on new vehicles is still too thin. Sources noted that triple-A spreads are lingering between Libor plus 175 basis points and Libor plus 200 basis points, which remains unattractive for equity investors.

Then there’s the issue of regulation. Under the Dodd-Frank Act passed earlier this year, securitizers are required to retain 5% of the security’s credit risk. This bill, though, was written for the ABS market, and it is unclear which entity in a CLO is the securitizer and which is the originator. This uncertainty could hinder the formation of new CLOs, sources said.

Another problem facing the CLO market is that a “natural investor,” particularly for triple-A tranches, needs to be found, according to Barclays.

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