In early January, Oxford Lane, a $260 million closed-end investment fund that specializes in collateralized loan obligations, went to unusual lengths to raise additional money to put to work. It entered into a sale-and-repurchase agreement with Nomura Securities, using $106.2 million of securities in its portfolio as collateral for what amounts to a $42.5 million, nine-month loan.
Nomura is getting an attractive return of 335 basis points over three-month Libor for what appears to be a low-risk investment, since it’s holding on to the collateral in the meantime.
But Oxford used the funds expeditiously: During a furious fourth quarter of refinancings and resets across the market that lowered liability spreads and sweetened CLO equity value, Oxford racked up $123.1 million in new CLO equity investments. Chief Executive Jonathan Cohen told analysts in an earnings conference call Thursday that the tightened spreads "presented us with certain opportunities."
"We’ll continue to try to catalyze as much activity across refinancings and resets as we possibly can,” Cohen said of the spread environment. “We think there’s a fairly clear path for a good amount of additional activity over the next several quarters."
It’s just one example of the innovative ways that money is being raised to invest in CLOs, which are backed by below-investment-grade corporate loans. At the other end of the spectrum, the Carlyle Group, itself one of the largest CLO managers, last quarter raised (another) $800 million to put to work in CLOs run by other managers in the U.S. and Europe.
All told, the estimated $10 billion put aside across the industry for just risk-retention capital alone (per a fourth-quarter JPMorgan survey) is one of the big reasons that this year’s CLO issuance is expected to match or even outpace the $124 billion of deals backed by broadly syndicated loans to small and midsize companies seen in 2017. The fast start to the year - with $6.6 billion in primary issuance the largest January volume in five years - appears to strengthen those projections.
Wells Fargo expects new issuance to increase slightly this year, to $125 billion, based on “large-scale” capital raising by managers to finance risk-retention stakes as well as the volume of funds to target third-party CLO investments.
Also buoying the market, says Wells, is the expected increase in first-time managers and a push toward more middle-market CLOs.
JPMorgan’s lower forecast of $115 billion is based on expectations for net new supply of $250 billion in senior loans in 2017 (the CLO supply since 2012 has generally ranged from 41% to 52% of the amount of year-over-year loan supply growth). Moody’s has a more modest forecast of $100 billion, based on rating agency’s expectation that many managers will refinance existing deals, in lieu of printing new ones.
Another $75 billion in refinancings and resets are expected to take place in 2018, per JPMorgan, far below the $165 billion level in 2017. As spreads on loans used as collateral keep moving in, CLO managers are increasingly willing to refinanced or reset rates on their own securities, even if it means triggering risk retention requirements.
For 2018, the favorable market for issuers (with average AAA spreads compressing to just 10x basis points in the first month of the year), heavy refinancing activity is expected to carry on, as evidenced by January’s level of $11.2 billion in resets and $2.5 billion in refinancings.
“Almost any deal issued over the past two to three years that’s coming up outside of non-call period, the triple-A at a minimum and certainly the mezzanine, is in the money to refinance,” said Mike Herzig, managing director at THL Credit Inc., in a December interview.
Credit quality
Refinancing isn’t just about lowering funding costs, however. It also allows CLO managers to deal with deteriorating assets that are affecting minimum spread tests by introducing more flexibility on the types of assets they can buy.
According to Fitch Ratings, 18% of 370 Fitch-rated deals in its CLO Index at the end of the year were failing to keep up the weighted average spread (WAS) requirement on their portfolios (roughly, the minimum difference between liability payouts to the finance costs of assets). That compares to 15% at the end of the third quarter; another 55%, or 204, were within 9 basis points of failing their tests, according to Fitch.
All these tightened WAS levels were the product of a nearly $900 billion refinancing wave in leveraged loans in 2017 that reduced cash flows to CLOs as borrowers reduced their interest rates. CLO managers’ only remedies were to refinance the CLO, trade for higher-yielding – and usually poorer quality – assets or adjust the so-called “matrix” of a portfolio’s average ratings factor or expected deal tenure (the weighted average life).
Over 40% of deals in Fitch’s index reduced their WAS triggers in the fourth quarter, potentially pushing deals out of compliance of collateral-quality, average ratings factor and averaged weighted life covenants on portfolios. (Managers have likened the exercise of adjusting these parameters to squeezing a balloon – pushing in on one puts more pressure on another element in the deal). Fitch said 18% of deals were also failing the Moody’s minimum weighted average rating factor tests, which measure the aggregate ratings for the underlying loans in a portfolio.
Moody’s believes managers may turn to more higher-yielding collateral that provides more cushion against deteriorating spreads they are receiving for the underlying loans. “For example,” Moody’s said, “they may structure [broadly syndicated loan] CLOs to hold more project finance or [small business] loans.”
Managers will also seek more freedom to adjust and modify the test levels themselves, often in a “trade off” the cushion on some tests for relief on others, according to Moody’s. One typical modification expected for 2018 is managers who will be allowed an increase in the minimum average ratings factor in a deal in exchange for an increase in the note’s par size limit (and introducing more weaker-quality loans into the portfolio).
Moody’s does not expect managers to beef up on more second-lien loans, however. While most deals permit as much as a 10% bucket of second-lien leveraged loans paying higher rates, the loans carry low recovery rates 37% below that of first-lien claims. In fact, Moody’s reported in September, CLO exposure to second-lien loan holdings have declined 35% since 2015.
Spreads
Although managers faced challenges in maintaining deal-quality covenants, they also benefited from the vast tightening of spreads in CLOs – involving both the senior AAA stack as well as the subordinate mezzanine tranches that saw remarkably lower spreads in 2017. AAA spreads that averaged 145 basis points in at the start of the year had been squeezed to 113 basis points by December – and further still to 106 basis points in January.
The tightened spreads made life easier for managers trying to achieve the right balance between cost of funds and investor payouts, but the lower rates have threatened to push investors out who may find the yield incompatible with the risk of investing in leveraged-loans (versus investment grade).
“Loan spreads compressing for CLO equity investors does have a negative impact,” said Gretchen Lam, a senior portfolio manager at Octagon Investment Partners. “At the same time they’re not having huge losses because of defaults and par losses, etc. You can’t have it both ways. You can’t have really high loan spreads and really low default rates at the same time, usually.”
Wells Fargo believes tightening spreads is a trend that will continue in the first half of the year despite the headwinds of “deteriorating credit fundamentals” and increased competition from a growing supply of CLOs as well as investment-grade fixed-income assets. But continued increased investor demand for floating-rate products may be so great that spreads on U.S. CLOs could tighten further even with increased issuance of investment-grade debt.
Wells sees that momentum possibly slowing down in the second half of 2018 as Federal Reserve rate increases and “removal and deceleration” of other central-bank stimulus programs globally could lead to flat or wider spreads, “especially down the stack,” Wells projected.
