Coming off a strong January for new deals, and encouraged by improved economic news, sentiment in the U.S. CLO market has taken a giddy skip from guarded optimism to bullishness — a little too bullish, according to some market participants.
True, there have been more than $2 billion in new CLOs, via six deals, priced since the beginning of the year, almost double last year’s level at this time, according to Standard & Poor’s. And there appears to be a healthy pipeline of new transactions, with analysts from Moody’s Investors Service putting the number of deals far enough along to reach roughly nine. Moreover, primary issuance spreads have narrowed relative to late-2011 levels, to around Libor plus 150 basis points, from the Libor plus 160-165 basis point range.
Still, bank and ratings agency analysts who held face-to-face meetings with CLO managers, investors and bankers at the American Securitization Forum’s conference last month have reported a mood among market participants that, in some estimations, may call for just a tiny dose of Lithium.
“I think it’s misplaced,” a CLO manager said. “Of course, the positive tone is for a good reason. There are signs of improvement, particularly in the U.S., signs of stabilization. And that’s the kind of environment where people become confident to put money to work again. And we are optimistic on the CLO market, but we’re not overly optimistic.”
According to Moody’s analysts, the general expectation for new CLO issuance among conference attendees was between $15 billion and $25 billion for the year. This is a nice little jump from late 2011 projections from analysts, which mostly called for a repeat of the $13 billion or so issued last year or a bit more, with an outside high of $20 billion. Indeed, in December, market participants were calling the $20 billion projection optimistic.
Most clients at the conference also think the technical backdrop favors incremental CLO spread tightening, subject to macro and regulatory risks, according to JPMorgan Securities analysts. Low supply, high investor cash balances, pay-downs in older deals and relatively wide CLO spreads are cited as the factors contributing to demand for CLO paper.
But not everyone is convinced that the new bullishness is completely warranted. Dave Preston, a CLO analyst with Wells Fargo Securities, is maintaining his forecast of $12 billion of new CLOs for the year, at least for now.
“Issuance last year was pretty lumpy. And this year, between the election here in the states and the continuing situation in Europe, much like last year, we believe there are going to be periods of positive sentiment followed by a crisis that induces fear,” he said. “Right now new issuance is moving along and spreads have moved in on the primary, but a year’s a long time.”
Moreover, market participants point out that they still face challenges to making a transaction’s arbitrage work. They also say demand has been weak for the mezzanine tranches of new deals. In short, just because a money management firm wants to do a deal or even gets so far as to launch a deal doesn’t mean it will be completed.
“What’s going on now is every manager and their mother is signing up with and investment bank to do a CLO,” said the CLO manager. “And the reality is that a significant portion of them are never going to get done. … People are getting all frothed up about the market, but there are challenges to execution that I don’t think people really appreciate.”
The problem, he said, is that there’s not a large enough supply of loans on the primary market, and the secondary market is so tight, that sourcing the assets to put together a deal that makes economic sense is difficult, unless triple-A spreads tighten in significantly from where they stand today.
“The market for liabilities and the market for collateral, although they may lag each other for periods of time, they are not so uncorrelated that you can have continued tightening of triple-As without a corresponding tightening of the loan market,” he said.
“You’ve got this bad arbitrage problem, and to get the type of spread that everyone needs, to get to a good arbitrage place, without the loan market tightening in correspondingly, you need a lot of demand for CLO debt and you need a lot of competition among players to help drive spreads in. And there is still a lack of depth in the buyers in CLOs.”
To be sure, some of the deals that have priced so far this year were planned last spring and were hung up during the market volatility of the summer. The same is true for a few of the deals still in the pipeline. One example is a $500 million CLO arranged by Nomura Holdings to be managed by Invesco. The deal was launched last spring and has yet to price.
Also said to be in the pipeline are deals from Octagon Credit Investors, ING, Credit Suisse Asset Management, Oak Hill Advisors, Providence Equity Partners and Onex Credit Partners.
Meanwhile, CLO strategists at Citigroup warn that in a scenario where macro conditions worsen considerably and capital markets stagnate (as they did in 2008-2009 and nearly did during August and September of last year), issuance will be significantly lower than estimated. “What could surprise to the upside is the greater involvement of regional U.S. and Asian financial institutions, but that would require several months of market stability, in our view,” they wrote in a recent report.
The Citigroup strategists, along with other analysts, also highlight upcoming regulation, such as the Volcker Rule, that may bring an end to the current trading trends. “European deleveraging, however, could increase the amount of trading as some banks will find it more attractive to sell assets rather than raise equity or finance assets in these difficult markets,” the Citigroup analysts wrote.