'Negative' forward calendar presents challenges for CLO issuers
Ultra low rates have prompted corporates to replace bank loans with unsecured fixed-rate debt, creating a “negative” loan calendar and forcing loan buyers to rely increasingly on the secondary loan market, pumping up prices of loans to companies that may still face major challenges.
Complicating matters, demand for CLOs bonds has tightened spreads, improving the economics for CLO issuers and prompting them to increase CLO issuance and increasing demand further.
Wells Fargo notes in its Sept. 9 “Key CLO Themes in September” that it anticipates “heavy” new CLO issuance through the end of October “as managers want to issue before the election, and CLO liability spreads have tightened, making issuance more economical.”
Gretchen Lam, senior portfolio manager at Octagon Credit Investors, said her firm sees a dozen or so CLOs in the new issue pipeline looking to “ramp up.” CLOs typically launch with 30% to 50% of their anticipated assets, intending to purchase the rest in the open market.
The increase in new issue CLOs emerged the week of Sept. 4, when six new issues were completed for a total of $2.6 billion, and the following week four deals for a total of $2 billion, following a month-long period when there were three or fewer new CLOs per week, according to J.P. Morgan’s Sept. 14 “CLO Weekly” report.
Last week, according to JPMorgan research, 12 new-issue deals totaling $12.4 billion were priced, making the highest weekly volume to date this year.
The increase in new CLO issuance has been driven by the tightening spreads of CLOs’ AAA bonds.
In its CLO Weekly report dated Sept. 21, JP Morgan recorded 206 CLOs priced in the U.S., totaling $79.5 billion, compared to 259 deals last year totaling $122.7 billion, a drop in part because CLO new issues halted during the onset of the pandemic in March and April.
“New issue liabilities tightened significantly in August and September, making the arbitrage better. So now we’re seeing more supply of new issue CLO deals,” said Neil Desai, managing director at Whitestar Asset Management.
The “arbitrage” refers to the difference between CLOs’ returns from investments and the interest paid to CLO bondholders, the so-called excess spread. CLO equity investors receive excess cash flows after debt investors are paid in full, so as that arbitrage increases so does attractiveness for equity investors, who typically own the loans, to launch new CLOs.
Complicating matters, however, is the dwindling supply of loans asset managers need to ramp up fully. Credit Suisse noted in a recent report that “continued negative net issuance” remains likely, as 10-year treasury yields remain well below 1%, providing corporate borrowers with extremely inexpensive financing without the uncertainty of floating-rate debt.
“We’re seeing a negative forward calendar of about $16 billion,” Lam said, adding, “That’s creating a very supportive technical picture” increasing loan prices.”
In other words, demand from the increasing number of CLOs and to a lesser extent other non-CLO buyers is increasing while the supply of floating-rate commercial loans decreases as corporate borrowers turn instead to fixed-income.
The AAA portions typically make up the vast majority of CLOs, so as more new CLOs enter the market those spreads have recently backed up somewhat, to upwards of 150 basis points over Libor, Desai said. He added they may widen a bit further and then likely return to the 120s as supply and demand normalize. Whether the widening spreads slow CLO issuance, at least temporarily, remains to be seen.
“At this point, we believe that issuance still works for equity investors, given tighter CLO spreads, the LIBOR floor benefit, and portfolio Weighted Average Prices below 99,” Wells Fargo said in its Key CLO Themes in September report. “However, should loans rally without significant movement in CLO liabilities, new issue may be more challenged.”
On the asset side, Lam noted that the riskiest loans have increased the most in price, as investors seek yields in today’s low-rate environment. She said loans rated CCC have run up as much as 10-plus points, and B- and BB-rated loans to a lesser extent.
The lack of supply has increased support for secondary-market loan prices, Lam said, as has the Federal Reserve’s monetary policy fueling investors’ confidence that the worst-case scenario—a capital-markets breakdown and a rash of corporate bankruptcies—is effectively off the table. Stronger than expected corporate earnings in Q2 were also a plus.
The negative loan calendar may be offset by an increase in new bank loans. The gestation period for new loans is upwards of six months, and “six months ago the sky was falling and there was no M&A, LBOs and other transactions that are catalysts for new loan issuance,” Lam said. “So it should be no surprise that we’ve seen a muted level of loan issuance compared to previous years.”
Countering the arrival of new loans, however, borrowers such as Advantage Sales and Avaya are prepaying loans, “which will only exacerbate the supply side,” Desai said.
Until the supply of loans increases, existing CLOs replacing credits that have been downgraded as well as new CLOs will have to rely heavily on the secondary loan market. Desai said a cynic might question whether some new CLOs will reach their ramping goals, given the loan pricing. “There may be a ramping problem,” he said, “Can you get the assets you want at the right prices?”
He added that he anticipates those deals likely reaching completion. However,
“This will just make secondary loan prices stronger which in turn could make secondary CLO BBs look much stronger on an MVOC basis,” Desai said, and those rich prices may not reflect their risk, especially if the pandemic takes an unexpectedly negative turn.
“Technical pressures have driven most loan returns lately but we haven’t seen the fundamentals keep up with this rally,” Desai said.