Loss of risk-retention would boost refis, but may crowd CLO credit quality
The elimination of risk-retention requirements for collateralized loan obligations could provide a further boost in CLO refinancing activity this year, according to Moody's Investors Service.
But the benefits of lower funding costs and more greater flexibility for CLO managers may be offset by weakened leveraged-loan underwriting standards, should a throng of smaller managers freed from taking skin in the game rush back in and overcrowd the market for loan buyers.
In a report issued Tuesday, Moody’s Investors Service cautioned that last Friday’s decision by the U.S. Court of Appeals for the D.C. Circuit overturning risk-retention requirements on open-market CLOs might be a mixed blessing.
CLOs could be exempt from skin-in-the-game rules as early April, pending any decision by federal regulators to appeal the decision after losing a civil lawsuit filed by the Loan Syndications & Trading Association challenging the rules.
On the credit-positive front, said Moody’s, a finalized court ruling could unleash a stockpile of 2015-vintage CLOs that held off refinancing last year largely due to risk-retention triggers. Moody’s says 73 of the 175 CLOs that the agency rated in 2015 moved out of their two-year non-call windows last year but did not refinance or reset deals although many “still bear a relatively high cost of capital.”
Risk retention didn’t preclude $165 billion worth of other CLO deals from refinancing last year, in order to take advantage of high investor demand and tightened spreads. But many of those deals were 2014-or-earlier deals eligible for the “Crescent” refinancing option that allowed deals to retain a limited exemption to risk retention. (Some refi deals were willing to assume new risk-retention features from a cost-benefit standpoint.)
“Because managers will no longer need to retain a risk-retention interest, the number of CLO refinancings will likely increase, a credit positive,” the report stated.
What may be a challenge for managers this year be an expected groundswell of newcomers (and market returnees) that many market observers expect to see as a result of the court ruling.
“You will start to see some smaller players get into the market that otherwise might not have been able to,” said Tom Majewski, chief executive and managing partner of Eagle Point Credit Capital, a CLO equity investor firm. “Among those with some degree of retention capital, very few had sufficient or long-term capital, so it probably helps things grow a bit faster.”
More buyers means increased competition for the short supply of syndicated, high-yielding loans from junk-rated corporates, in a market already off to a frothy 2018 start. Loan bid prices are up $0.54 on the year, compared with just $0.20 for all of 2017, according to JPMorgan high-yield research. And the Markit IBoxx Index for the most heavily traded leveraged loans is up 0.83% in the first six weeks of the year as loan demand continues to surge.
To add new buyers into this mix, Moody’s warns, could add pressure to CLO spread and collateral-quality tests. Leveraged-loan issuers could extract even more favorable terms in their refinancings with more managers bidding for their debt, pushing interest rates lower. Lower rates combined with limited supply would also draw more buyers toward lower-rated loans to fill up CLO portfolios and maximize the "arb" between debt and liability costs.
“If increased competition contributes to further deterioration in loan underwriting quality, then the effect would be credit negative for CLOs,” Moody's said.
(Moody's noted two potential limited CLO benefits from a continuing leveraged-loan refi wave, which hit a record $933 billion last year: a lower risk of default for some borrowers attaining lower interest rates, and"small overcollateralization increases" for managers who redeem refinanced notes at par on loans acquired with original issue discounts.)
The appeals court’s decision on risk retention by a three-judge panel is still pending a possible — though unlikely — appeal by the Federal Reserve Board of Governors and the Securities and Exchange Commission to the full court in an en banc hearing. The Fed and SEC could instead choose to appeal to the U.S. Supreme Court within 90 days, but the appeals court decision would still go into effect pending the outcome of upper-court review.