Ever since the credit drought set in, loan market participants have been wondering when a new CLO would fall from the sky. There have been a number of predictions regarding CLO activity over the past year or so, but only a few have actually materialized. However, now that conditions have improved, some market participants think a CLO storm cloud is just over the horizon, and they expect to see new CLOs in another six months or so.
"I have heard that some underwriters are approaching the largest CLO managers about potential deals in 2010," a West Coast-based investor said. "It is not clear though if these are bankers trying to create something and then find buyers, or if they have demand from liability buyers."
"When will the loan market see new CLOs?" is a question coming up with both buy-side and sell-side participants. It was even on the agenda at the Loan Syndications and Trading Association (LSTA) conference, which took place in New York last Thursday. Participants are asking this question because secondary prices have rallied, new loan issuance has picked up, and because of the level of deleveraging taking place among issuers - all signs of an improving market.
The average triple-C loan bid has returned to the upper 70s, a level that was last seen prior to the Lehman Brothers bankruptcy filing, according to the Standard & Poor's/LSTA Leveraged Loan index. Single-B prices have increased by 57% year-to-date. These have particularly helped CLOs that hold a lot of downgraded loans. Meanwhile, the average triple-A spread has dipped well below 400 basis points, which is where spreads were in the summer of 2008.
As a result, on the back of improving loan prices, more than 12% of those CLOs that were failing their junior overcollateralization tests in June, and were at the same time deferring their subordinate management fees, are now passing their tests and have turned the subordinate management fee faucet back on, according to PF2 Securities Evaluations, which evaluates CLO performance. This has helped managers build cash that could be put to work, sources said.
Another encouraging sign: the percentage of CLOs violating their OC tests has dropped below 45% from the peak reached in June, which was around 57%, according to S&P Leveraged Commentary and Data.
The CLO market is obviously no where near as stable as it was for most of the decade. Triple-A spreads, for example, were lower than 50 basis points between January 2005 and mid-2007. And a market which saw billions, even more than a $100 billion, issued in a single year seems like an alternate universe compared to today's reality. But the point some CLO market participants are making is that it's not where the market has been, but where it is going.
"[The CLO market] is definitely getting better, and I could see some new issuance by the end of the second quarter in 2010," a New England-based CLO manager said.
And as the market improves, investors have come out to play. One CLO manager at a large investment house said his firm has raised more than $1 billion through separate accounts for investments in CLOs. "We've heard that there may be new CLOs in six months. We're pretty optimistic," he said. "There have been more conversations taking place in the past month or so about this."
A CLO market analyst in New York pointed out that another positive barometer for the CLO market is the fact that banks are hiring again. "It looks like they're positioning themselves for new issuance," he said. "I can't say that it's for CLOs, but it wouldn't surprise me at this point."
Others, however, say they would be surprised if the CLO market saw any new issuance in six months time, because conditions are still too rough.
"Why buy a new CLO when most CLO tranches are trading at a discount between 40% and 80%?" a New York-based investor said. "Also, the spread that would be necessary would cause any CLO structure to be unprofitable. Whoever told you that CLO's are coming back has some really good drugs."
A Boston-based investor added, "I'm still bearish on CLOs. I think it will take well over a year for the market to see any new CLOs. And when it does, CLOs are going to look a lot different, with only a triple-A tranche and an equity tranche. A lot of the pressure within CLOs has been alleviated in the past few months. Most CLO managers are passing their triggers but there still are a lot that aren't. Almost half, or 40%, of the CLO market still isn't receiving subordinated debt fees, and there are still a number of CLOs that aren't performing as they're should be."
Several CLO market participants noted that the arbitrage between the senior financing and the yield on other assets, mainly those that are trading on the secondary, will continue to make it difficult for any new CLOs to launch. "You need two pieces - attractive equity rates and reasonable financings - to create that arbitrage," said another New York-based CLO manager.
There is also the concern that traditional CLO buyers are just not there anymore and may never come back. "CLO buyers have been devastated with all the SIVs and other toxic assets," the New York-based CLO manager said. "People just got blown up. And the other complication is that there are not many desks left. There are few people who can do CLOs anymore. It's probably a handful."
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