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Simmering skepticism for 2020 CLO market issuance, spread environment

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Despite strong economic indicators heading into 2020, many observers of the collateralized loan obligations market are on edge.

Skepticism stems in part from concerns over the end to the current long-running credit cycle. That has driven leveraged lending but also drove up multiples at which private equity firms are acquiring companies — encouraging bulging levels of leverage on corporate books.

In addition, the prevalence of “covenant-lite” loans and allegations of inflated earnings for speculative-grade rated corporate borrowers could provide little warning about upcoming defaults … which could result in hyper-vigilant rating agency downgrades, leading to overcollateralization-test breaches and deals amortizing prematurely.

On the other hand, the U.S. economy continues to chug along, and market participants expect the Trump administration to use the tools at its disposal—trade policy, farm bailouts, etc.—to keep it that way until after the presidential election.

“It is possible that spreads could tighten early in the year as investors put fresh allocations to work,” said David Heilbrunn, a longtime participant in the CLO market and head of product development and capital raising at Churchill Asset Management. “But I think market skepticism is likely to keep things where they are for awhile.

“Investors in equity and lower rated portions of the capital structure are especially concerned about OC-test breaches, because they don’t want deals to amortize,” Heilbrunn added.

The CLO market enters 2020 coming off strong 2019 primary issuance of approximately $117 billion, which was slightly down from a record year in 2018 but above average compared to historical numbers.

Most analysts see a drop in issuance volume to between $90 billion to $100 billion, but also with a decline in overall supply of deals that could favor a spread-tightening environment.

“We see the CLO market as caught between opposing forces: compelling relative value and a drop in net supply” which should promote spread tightening – which lowers the premium paid to investors, according to a report from Wells Fargo analyst David Preston.

Tighter spreads on the primary Class A notes in deals would come as good news for managers who saw CLO spreads widen in 2019. But many market participants, including Wells, still expect spreads to maintain current levels, or even to widen slightly.

Wells Fargo Securities’ base-case scenario, described in a Nov. 27 report, predicts AAA tranches staying wide of corporate debt but ending the year at more or less the same level, around 134 basis points over Libor.

It sees spreads on double-B rated notes ending the year “marginally wider,” at 825 to 850 basis points, up from around 765 basis points to begin the year.

Some market participants are more sanguine about CLO prospects. Thomas Majewski, CEO of Eagle Point Credit Co., expects AAAs to tighten to 125 basis points over Libor and BBs “to continue tightening into the 600s in the short term,” partly because he sees market concerns about a rash of loan downgrades to be overblown.

“We believe equity overall will continue to generate strong cash flows,” he said.

In addition, Majewski said, few managers of so-called risk-retention CLOs have raised second funds, dropping those funds’ share of the market from a third or so to 10% of CLO supply. Those funds were structured to retain at least 5% of the credit risk under regulatory requirements that have since been overturned, providing attractive fees to managers despite often underwhelming performance, according to Majewski.

“We estimate overall 2020 CLO volume at about $100 billion for new issuance, $20 billion for resets, and $30 billion for" refinancings, Majewski said.

Steve Vaccaro, CEO and chief investment officer of CIFC Asset Management, which manages more than $19 billion in CLOs, also expects CLO debt spreads to tighten in 2020, “as the headwind from rapidly declining interest rates eases, loan fundamentals remain relatively healthy, and the premium vs. other risk asset classes including fixed-rate investment grade and high yield corporate bonds compresses.”

CIFC predicts new issuance will fall to between $80 billion and $100 billion, in part due to high corporate valuations slowing the pace of acquisitions and uncertainty surrounding international trade, the presidential election, and market-share competition from the high-yield market.

Vaccaro added that CIFC views this period of stress “as an opportunity to assess manager performance.”

In a recent report about the Opal Group’s CLO conference in early December, S&P Global said it also anticipates new-issuance volume in the $80 billion-$100 billion range. However, it notes that concern about downgrades was common theme among the more than 20 investors in attendance. A spike in defaults was less of a concern in the near term, the report adds, but investors are diversifying their portfolios and emphasizing a “conservation of par” rather than spread.

S&P Global says CLO investors and managers broadly agree that environmental, social and governance (ESG) issues are growing in importance, and they will need key performance indicators to monitor and report progress in ESG.

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