The middle market CLO sector has seen a rash of rating agency upgrades this year. And while credit quality is expected to remain strong despite new managers and collateral choices, the rosy performance can be attributed largely to structural development. The sector only in the last several years has begun to diverge from traditional sequential-pay structures and static portfolios, and continued innovation is expected.
"The biggest story was the development in middle market CLO structures leading to redeemed notes," said Fitch Ratings analyst Christine Choo last week. Within the 21 middle market CLOs the rating agency reviewed between May 18, 2005 and July 31 of this year, Fitch upgraded 14 tranches (three of which were upgraded twice) and affirmed 55; 23 tranches that were paid in full. The rating agency has yet to downgrade any middle market CLO, the first of which it rated in 2000.
Fitch said last week that it is expecting the middle market CLO sector to continue to perform well. Prepayment activity, new structures and stable collateral credit quality are expected to remain the main drivers of positive performance - and even though prepayments are anticipated to slow amid rising interest rates, the shift does not necessarily equate to lower loan credit quality, the rating agency said.
American Capital Strategies was the first issuer in 2004 to step out of the static portfolio mold when it issued ACAS 2004-1. The deal included a principal reinvestment period - a feature that had yet to grace the middle market CLO sector, which has historically lacked the secondary market liquidity to make such a structure work. By 2005, three of five deals issued included revolving periods, and as of July 31, three of four deals have included the feature, Fitch reported. CapitalSource's CapitalSource 2003-2 deal was among the first to include a pro rata pay structure. Specialty finance company NewStar Financial in June closed its $500 million NewStar Commercial Loan Trust 2006-1 deal, which was among the first middle market CLOs to include both a pro rata pay structure and reinvestment period (ASR , 06/19/06).
As CLO spreads squeezed tighter and tighter in 2005, more managers looked to middle-market loan collateral as a higher yielding collateral alternative. As a result, 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. JPMorgan Securities estimated in April that middle-market CLO issuance is on pace to reach $16 billion to $18 billion by yearend.
But while increasing liquidity to the middle-market CLO space may be inevitable given the level of demand, "growth in this space may be a two-edged sword," JPMorgan analysts said. The middle-market CLO sector has matured along with the influx of liquidity along with compressed prices and improved quality of reporting and analysis. However, the problem occurs when the more receptive secondary market results in an erosion of underwriting standards and new, less experienced issuers in the space, market players have noted.
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