As increasing demand ground CLO spreads tighter and tighter in 2005 - so much so that a number of deals were at risk of breaching spread requirements - more managers looked to middle market loan collateral as a higher yielding alternative.
In fact, loans from these smaller, regional issuers became more popular than ever last year, when U.S. middle-market CLO issuance reached a record $10.6 billion. According to JPMorgan Securities, middle market CLO issuance is on pace to reach $16 billion to $18 billion by yearend.
However, JPMorgan analysts point out that while increasing liquidity to the middle market CLO sector may be inevitable given the level of demand, "growth in this space may be a two-edged sword." The middle-market CLO sector has matured along with the influx of liquidity, with compressed prices and an improving quality of reporting and analysis. The problem, however, occurs when the more receptive secondary market results in an erosion of underwriting standards and new, less experienced issuers in the space, JPMorgan analysts wrote last week.
Potential investors should scrutinize new managers in regard to how much experience they have, underwriting approach, systems capability and staffing levels, according to JPMorgan, although there is opportunity to find well structured deals that are priced to compensate for the less established managers. For arbitrage middle market CLOs, the most relative value can be found in the top of the capital structure. In this case, an average two basis point pick-up at the triple-A level is likely a better option than a five basis point gain at the triple-B level, given the risk, JPMorgan wrote. Meanwhile, balance sheet middle-market CLOs have typically priced inside standard CLO liabilities across the capital structure - meaning that investors should consider the shorter average lives of the transactions, protective features of the deal and the manager's performance incentive, JPMorgan recommends.
Double-B and double-B minus-rated institutional loan spreads tightened from more than 400 basis points over Libor in April 2003 to less than 200 basis points over Libor in July of last year. And as of October, 45% of 2001 vintage CLOs were failing their weighted-average spread requirements, and 40% of the 2000 vintage is failing, while the more recent 2002, 2003 and 2004 vintages were failing at rates of 15.79%, 11.36% and 7.46%, respectively.
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