Over the past year, there has been considerable discussion around the 'refinancing cliff' and the looming gap between the supply and demand for leveraged loans.
As the market has worked through some of the earlier loan maturities, Fitch Ratings believes the 2014-2015 refinancing cliff will be less dramatic than the absolute debt amount suggests. Markets have historically (and continue) to adapt to supply and demand mismatches with new products, unique market variations and adjustments to pricing and terms.
Approximately $391 billion of institutional term loans, or 80% of the outstanding institutional loan market, are due to mature by 2015. While refinancing sources are likely to remain strained over the next few years, options are still available to issuers with looming debt maturities. Additional capacity in the leveraged loan market, amend and extend agreements and bond for loan take-outs have successfully pushed back the maturity wall and will continue to absorb demand through the near-term.
CLO investment is a significant component to capacity in the leveraged loan market. Fitch estimates that CLOs hold over 50% of all outstanding leveraged loans in the market today. While legacy CLOs continue to provide capital to the loan market through reinvestment of proceeds during the reinvestment period, the majority of outstanding CLOs will exit their reinvestment periods by the end of 2013. This will materially curtail the proceeds available to purchase new loans and significantly reduce the supply of dollars to the market.
Legacy CLOs beyond their reinvestment periods may continue to address pending maturities with amend and extend agreements to the extent that revised terms fit within investment guidelines, particularly the weighted average life covenant. Amend and extends may have a positive impact for CLO investors in that they generally include Libor floors and an increase in pricing. All else being equal, these modifications improve the excess spread available within the structure but also extend the duration of the CLO notes.
New CLO issuance will be critical to maintain, and ultimately improve, the current capacity of the leveraged loan market to work through upcoming maturities. Fitch expects only moderate CLO issuance in the near term, with $3 to $4 billion projected for 2010 relative to the market's peak issuance of $500 billion in 2006. Immediate challenges to new CLO issuance include:
* Transaction economics;
* Interpretation and adoption of new regulatory requirements; and
* The development of a new investor base.
Positive historical performance through the recent downturn combined with stronger fundamental credit in the loan market should translate well for a re-emerging CLO market. Going forward, CLO structures will be less levered, which will mean simplified structures and relatively larger equity investments. Initially, a smaller equity investor base will limit CLO issuance in the near-term. New investors, however, will be attracted to the space for its positive historical performance and diversified access to the US loan market.
Fitch projects issuance to pick up in 2011 as the market works through these challenges. However, the volume of new issue CLOs may not keep pace with the growing number of CLOs exiting their reinvestment periods. The market may react to the supply and demand imbalance by setting a new clearing price for leveraged loans. This gap in capacity may prove to be the catalyst for improving transaction economics and prompting primary CLO issuance.
Barring any catastrophic adverse economic conditions, the leveraged loan market will find a clearing price and associated terms at which much of the demand for credit can be satisfied. Market forces will work to ease the pressure created by the combination of pending loan maturities and the amortization of legacy CLOs. The refinancing cliff that might otherwise have resulted in an unparalleled spike in loan default volume may yield attractive conditions for a re-emergent new issue CLO market.