With history as a guide, collateralized loan obligations may be in store for a somewhat bearish summer in terms of spreads, reversing the recent trend.
Widening spreads have been a consistent staple in the June-through-August time frame for each of the past four years across the capital stack.
Triple-A spreads, for example, have widened by at least 15 basis points each summer for three of the past four years, and have widened or been flat in the mezzanine classes of single-A through double-B rated tranches.
“Even in 2012, when triple-B spreads were flat from June to September, spreads actually moved wider by 100 basis points between mid-May and early August, before an August rally pushed spreads back to May levels by mid-September,” analyst David Preston wrote in a June report.
This prediction flies in the face of forecasts by many CLO market observers that triple-A spreads will continue to shrink to as low as the 120s area (down from the 150s just over a year ago).
But the summer spread expansion has been consistent since 2011, when the CLO market began its rebound from the post-crisis era.
Unfortunately for analysts, the reasons are not easily discernible.
Given four years could be a small sample size, Preston writes that individual events for each of the past four summers may have coincidentally played a central role in spread widening through “risk-off” moves by investors, producing lower demand (the events include the U.S. debt ceiling crisis and downgrade in 2011, JPMorgan’s “London Whale” episode of 2012, and the 2014 extension of the Volcker rule extinguishing hopes of its appeal).
Summer holidays are often cited as a reason for seasonal spread widening in other kinds of securitization, such as asset-backed securities and collateralized debt obligations; the idea is that fewer participants equates to lower trading volume. But Preston says that TRACE data indicate there is no distinct pattern of trading volume trending up or down in the summers of 2011-2014.
That leaves increased CLO issuance, which market participants have “long cited” as a cause of flattened or wider spreads. “From H2 2013 until Q1 2015, CLO supply was essentially equal to CLO demand; new managers issued CLOs, and deals were upsized to meet increased demand. As a result, it was difficult for spreads to move tighter when supply and demand were equal,” wrote Preston.
While issuance volume certainly factors into spreads widening or tightening, Preston’s report indicates that there this does not appear to be a main cause for the recent summer trends.
In looking at the CLO issuance volume during May to August in all four years in which spreads annually tightened across classes, only in 2011 and 2014 was primary issuance at its peak for the year (36.5% and 31.2%, respectively). But in 2012 and 2013, the May-August periods were under 21% of each year’s total issuance. “[I]ssuance was concentrated in the latter half of the year, specifically in late Q3 and Q4,” the report states.
So far this year, issuance has been relatively strong, particularly in light of lighter issuance of leveraged loans used as collateral. But Preston expects that both low loan issuance and concerns about risk retention rules will start to weigh on issuance this summer, and beyond.