European CLO spreads have tightened beyond the levels seen late last year into the first quarter of 2005, but Dresdner Klienwort Wasserstein analysts argue that spreads may have reached a plateau and more discrimination between deals is likely to follow.
The market this year has already seen 10 transactions price, which puts volumes at 4.3 billion ($5.3 billion) - a 102% increase over on 2004 half-year volumes when six transactions were launched. Standard & Poor's recently reported that most managers have been working on new transactions that have yet to reach the market. Up to 12 new transactions are expected to come to market over the next few months from established European loan managers, as well as transactions from newcomers to the CLO market (including some new European boutique managers), and established U.S. managers with nascent CLO operations in Europe.
So far three of these expected deals have priced in July - Avoca III, Silver Birch and RMF III. The next deal expected to reach the market is the Alcentra-managed Wood Street deal. According to analysts at DrKW, several deals from new managers, as well as established ones, have been announced. Issuers include Prudential Financial, which is expected to come to the market soon with its first European CLO fund, and Credit Suisse Asset Management, which is looking to price a 400 million to 450 million transaction in the fourth quarter. A new deal from the Carlyle Group is in the works as well as talk of JP Morgan Securities preparing a 350 million to 400 million fund for AIB Capital Markets.
Last year, leveraged-loan CLO spreads experienced a significant tightening trend in both the primary and secondary markets. After some initial tightening this year, by the end of June and into July, new issuance saw notes go out a bit wider but still inside levels seen last December - spreads reached a plateau at the 24 to 28 basis point range for triple-A notes. According to DrKW, The spread pickup available for investing in triple-A leveraged loan CLO tranches, as opposed to triple-A RMBS, has gone down from 42 basis points in January 2004 to 14.5 basis points currently.
Some pickup between CLOs and RMBS is expected to linger on the back of the longer weighted average life, lower levels of granularity and liquidity, the nature of the underlying assets and the reliance on an asset manager. As a result, analysts said they expect to see increased discrimination on CLO managers - a trend that has already been evident in some of the deals that have priced so far this year. "We expect new managers will find it harder to come to market and may price wider than deals by managers with a good track record," said analysts at the DrKW.
Although CLO performance has been stable in the first seven months of the year, signs of weakening in the underlying credit quality in new leveraged-loan issuers, coupled with an increasing proportion of single-B rated debt in the European leveraged-loan market is on the rise. Analysts at DrKW said that leveraged buyout issuance is up significantly - particularly for institutional loans, the most commonly securitized loans. Until now, strong demand has maintained the tight spreads, while the average credit quality of new deals continues showing signs of weakness. Spreads have widened by three basis points but remain broadly stable at 29 basis points over Libor, said analysts.
But there are signs that discrimination based on credit quality is beginning to have an impact. Standard & Poor's reported that for the first half of this year spread levels for BB' and BB-' credits, at were 22.1 tighter than levels for B+' and B' credits. This compares to a 3.1 basis point difference in the second half of 2004 and a mere one-half of a basis point difference in the first half of 2003. In the first half of 2002, there was a five basis point difference.
"Both new CLO issuers and, due to the high prepayment rates, existing deals, may find it increasingly more difficult to keep the average quality of their portfolios up, which means that it is now more important than ever to focus on the quality of the manager, and the portfolio," said analysts at DrKW.
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