The pace of collateralized loan obligation (CLO) issuance is expected to remain strong in 2006, as long as leveraged loan issuance, liquidity, default rates, liability and underlying collateral spreads, and investor demand for CLO equity remain stable this year, according to market sources. The consensus is that issuance should be at least on par with or higher than 2005's CLO issuance levels.
According to preliminary data released by Moody's Investors Service, more than 90 U.S. CLOs were issued in 2005, totaling about $42 billion. This compares with 57 Moody's-rated CLOs issued in 2004, totaling about $22 billion. Standard & Poor's also reported a rise in CLO issuance, according to its 2005 data, which show 99 US S&P-rated CLOs issued in 2005 to total about $47 billion. This compares with 66 S&P-rated CLOs issued in 2004, totaling about $26 billion.
There is a very deep pipeline for new CLOs and no slowdown in issuance is expected anytime soon, said William May, managing director at Moody's. "Managers are ramping up more deals than ever." And CLO equity investors from Asia, Europe and North America continue to show interest, he said.
"I think [CLO issuance in 2006] will be robust," agreed David Ardini, CLO portfolio manager for Franklin Templeton Investments' Franklin Floating Rate Debt Group. "I don't think we will see too much more in 2006 over 2005 than we saw in 2005 [compared with] 2004. But we still could very well see 20% growth," he said. "Right now, there is a strong CLO pipeline and, generally speaking, the economy's outlook is good.... The key has been access to collateral, and loan issuance has been fairly robust," Ardini added.
Historically low default rates, despite having risen since 2004, have also helped maintain investor allure to the leveraged loan asset class. Moody's reported a 1.8% issuer-weighted US leveraged loan default rate at the end of 2005, compared with a 1.6% rate at the end of 2004. Meanwhile, S&P reported a 1.98% US leveraged loan default rate at the end of 2005, compared with a 1.12% rate at the end of 2004. S&P expects loan defaults to remain below average this year, sliding back to 1.25% by December 2006. "Liquidity remains plentiful, and the distress ratio -measured as the percentage of performing loans in the US trading at prices below 80 cents on the dollar - still remains near record lows, wrote S&P managing director Diane Vazza in a January 6 default report.
CLO investors have also been attracted to the loan market's strong liquidity levels. "There are strong technicals in the [collateralized debt obligation (CDO)] marketplace.... There are also many new CLO managers, and a lot of loan demand is coming from the hedge funds," Ardini said, explaining reasons why liquidity in the loan market has been so robust.
And the low Libor spreads on leveraged loans, which have resulted largely because of the high competition for loan paper by investors, appears to not have hurt the prospects for CLO issuance - at least not yet. That's because CLO investors have been accepting low liability spreads in tandem with lower leveraged loan spreads over Libor.
Ardini noted that triple-A liability spreads have averaged Libor plus 26 basis points or lower for about nine months now. "They probably will not go tighter, but they could stay at that level for some time into 2006," he said.
But despite the consensus that strong CLO issuance should continue well into 2006, there are still scenarios that could jeopardize issuance, market sources pointed out. One central risk relates to the chance that CLO investors might flee loans for more profitable asset classes. "Given the current level of returns in the CLO market, rising default rates, and other asset classes starting to perform better, [will] money and investor interest shift away from CLOs?" another CLO manager asked. "Is the demand from CLO investors sustainable at this level?" he continued. "The returns on CLOs have been acceptable to equity investors only because the liabilities have been priced so tight that, despite the tight spreads on loan collateral, equity returns are still better than [in] many other asset classes. If either of them - equity buyers or liability buyers - wants more return/yield and loan spreads don't widen out commensurately, the arbitrage [might] really shrink to an unattractive level." He noted that investors might begin to look to the stock market, for example, for higher returns. "If liability spreads widen out and loan collateral spreads do not, the equity returns will fall to a level where buyers probably are no longer interested in CLO equity, which would definitely impact an issuer's ability to get new [CLOs] done," the CLO manager explained.
He noted that even though default rates have risen slightly, the spreads on loans have remained at all-time lows. "In a normal market, default rates rise and that leads to a natural widening of spreads. But that is not happening in a substantial way due to the strong technical conditions of the market," he said, referring to the high amount of loan demand coming from CLO managers and other types of institutional investors.
The average spread on BB/BB- rated institutional loans was at Libor plus 185 bps in December 2005, while the average spread on B/B+ rated loans was at Libor plus 263 basis points, according to S&P's Leveraged Commentary & Data.
That being said, loan spreads may begin to widen out more if demand for them decreases due to certain loan investors exiting the market for more profitable ones. For example, if rates stabilize, some investors may switch to investing in bonds. "If the [Federal Reserve Board] stops raising rates, you could see investors move back to bonds," said Tyler Chan, director of research for the Franklin Floating Rate Debt Group. "Total return investors might start moving away," he explained.
In addition to concerns about loan spreads not increasing at the same pace as liability spreads, market players are also concerned about the growing amount of lower quality loan paper clearing the market. If CLO managers continue to invest in a high number of lower quality deals, they are increasing their portfolio's chances of hitting trouble down the road, market sources said.
"Although deal flow is heavy, the percentage of those deals that are marginal credits is increasing," said Chan. He explained that investment bankers are filling a gap by issuing more of these lower quality loans in order to create enough supply to meet investor demand. In addition, bankers are beginning to alter certain deal structures so that loan investors receive a more subordinate debt position on a company's collateral, Chan said. For example, the $3.85 billion bank deal to back the buyout of Hertz Corp. includes bank loan debt that is more risky because its collateral is Hertz's trademark instead of its fleet of rental cars, he said.
Increasing investments in different types of debt, such as second lien or middle market loans, could also raise the level of performance risk for CLOs. "It is clearly a riskier proposition to buy second lien loans, high yield bonds and middle market loans," said Moody's' May. CLOs often include buckets to invest in other forms of debt such as high yield bonds, second lien loans, middle market loans and synthetics.
If CLOs do start to experience more trouble due to their investments in riskier forms of debt, such as middle market loans, it is the new and more inexperienced CLO managers that might face the most problems. "It is not necessarily the case that a [good] loan manager is going to be a good middle market loan manager," said Mark Froeba, vice president and senior credit officer at Moody's. "Also, a smaller shop might not have the resources to get good experience investing in middle market loans outside of a CDO," Froeba said.
New kinds of CLOs
However, as CLO issuance continues to remain strong for now, an increasing amount of CLO managers are devising alternative types of CLOs.
For example, as issuance of middle market CLOs increases, market sources expect to see more creative middle market investment structures. "Recently-launched middle market loan CDOs have also included buckets of asset-backed securities and loans from the broadly-syndicated markets," reported Fitch Ratings in a December 2005 structured finance outlook report. "In addition, Fitch has noted a trend in middle market CLOs that follow more traditional CLO structures and utilize overcollateralization and interest coverage tests."
"With respect to middle market CLOs, we are definitely expecting more issuance than last year, as well as different types of CLOs with different assets in them," said Alla Zaydman, a director in Fitch's credit products group.
Synthetic CLO issuance could also increase this year, especially as an ad hoc committee comprised of investors and bankers moves closer to releasing proposed standard documentation for synthetically referencing loans on credit default swaps to rating agencies, The Loan Syndications and Trading Association and the International Swaps and Derivatives Association. "CLO issuance (in synthetic form) may accelerate in the relatively near future if the market responds favorably to the upcoming ISDA templates for synthetically referencing loans," stated Moody's in a third quarter CDO review released in December 2005.
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