Asset managers are scurrying to bring new CLOs to the market to capitalize on the healthy appetite for the structured product while a previous generation of CLOs is winding down.
Equity holders are electing to call older vintage deals, in part, because some are seeing their returns squeezed by tightening spreads in the leveraged loan market. They would often rather reinvest the capital in new deals. And for the CLOs that can no longer invest in new deals, the rapid rate of loan repayments has depleted the number of loans left in CLO portfolios.
While market analysts say the number of CLOs entering the market exceeds the number of optional redemptions, there was a spike in the number of calls last year. In 2005, equity holders opted to call 28 cash flow CLOs compared with only four in 2004 and none in 2003, according to Standard & Poor's CDO surveillance group. So far in 2006, this trend appears to be continuing. As of Feb. 10, five CLOs had been called.
Stephen Anderberg, who heads S&P's CDO surveillance group in New York, attributes the wave of CLO redemptions in large part to the rock-bottom Libor spreads that have persisted in the loan market for some time.
Shrinking new issue spreads present a challenge for CLO managers because, while the liability cost structure of a CLO is typically fixed, the prices of the loans in the collateral pool are not. If the AAA' tranche pays a spread of Libor plus 40 basis points, that is what it will pay regardless of the weighted average spread of the collateral pool.
"What that means for the equity is that they are getting squeezed, and their return profile is getting lower," he said.
According to S&P's Leveraged Commentary & Data, spreads for BB/BB'-rated institutional loans were at an average of about 175 basis points over Libor in the fourth quarter of 2005, which is less than half the average spread of 388 basis points over Libor seen in the fourth quarter of 2002.
Gregg Jubin, a partner in the capital markets department in the Washington office of Cadwalader, Wickersham & Taft, said for equity holders in deals that have passed their no-call period and are nearing the end of the investment period, it is often in their best interest to call the CLO.
"The bank loan market continues to be strong - many of the assets held by the CLO are trading at a premium and a good way for equity to realize that value is to call a deal," he said. "If you are tailing off to the reinvestment period, you can eke some more value out of the CLO, but you are subject to both general market risks and risks in the bank loan market. Simply put, it is a chance to lock in gains."
Tightening loan spreads are not the only factor at play. Along with narrowing spreads in the loan market, liability spreads have tightened as well, said Douglas Lucas, executive director and head of CDO research at UBS.
"Liability spreads have been shrinking because of the popularity of CLOs," Lucas said. "Everybody loves loans - it is a floating rate asset, which makes it an attractive investment when people think interest rates are going to rise, and it has low default rates and high recovery rates. There's a risk of equity underperforming if loan spreads continue to tighten."
This could prompt some investors to flee the CLO market for an asset class with a more profitable yield, though he and other CLO experts don't expect that to happen soon.
"The CLO pipeline is very strong. Loan spreads have tightened over the last couple of years and CLOs continue to get done," he said.
He added that as new issue spreads have tightened, so have CLO liability spreads, keeping the arbitrage of the vehicle in balance.
But for some of the older vintage CLOs - particularly those that closed in 1999 and 2000 - declining spreads aren't the main issue. The rapid pace of loan repayments is.
Such was the case with Stein Roe & Farnham CLO I, which was called in January.
"Because there is so much refinancing in the market, a lot of the loans in the portfolio were prepaid," said Ty Anderson, formerly head of the CLO team at Flagship Capital Management, which managed the CLO. "It delevered so much that it didn't make a lot of sense for it to remain outstanding, even though the overall equity returns were excellent."
While the firm did not recommend calling the transaction, Anderson said Flagship brought the issue to the equity holders' attention. Most of them voted to call the deal.
"I am sure you are going to see a good deal of CLOs called this year. One of the first big years of CLO issuance [was in 2000]. These deals are now past their reinvestment period," Anderson said.
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