Editor's note: This is the first in a series of 10 articles revisiting some of our most-read stories of the year.
CLO managers started 2017 off avoiding risk retention and ended up embracing it.
In the first few months of the year, many took advantage of a no-action letter from the Securities and Exchange Commission to refinance older deals, under certain circumstances, without triggering skin-in-the-game rules. This is a one-time exemption, but there was a big incentive to act quickly: Many of the leveraged loans in their portfolios were being refinanced, forcing them to accept lower spreads. CLO managers needed to lower their own funding costs, too.
But by midyear, many had raised large amounts of capital to put to work in the equity, or riskiest slices of their deals. This allowed mangers to resume issuing new deals just as new loan issuance was taking off.
Some managers even opted to refinance deals that were eligible for the one-time exemption in such a way that triggered compliance. They decided it was worth extending the life of aging deals or making other changes not allowed under the “Crescent” no-action letter.
By the end of November, over 540 broadly syndicated CLOs – both new issuance and refinancings – had been printed, according to Thomson Reuters LPC. New-issue volume alone had topped $108 billion by the end of November, well surpassing the 2016 total of $98 billion and nearing the market record of $124 billion set in 2014.
Despite this heavy issuance, yield spreads compressed significantly over the course of the year. In January, spreads on triple-A-rated tranches averaged 150 basis points over Libor; by December, this had narrowed to 116 basis points, according to Thomson Reuters. Several deals by established managers like Ares Management and Carlyle CLO Management priced their senior tranches below 110 basis points.
Spread tightening occurred across the capital stack, however. Even spreads on triple-B-rated mezzanine tranches narrowed by as much as 120 basis points, thanks to demand from a new segment of overseas investors (including China) looking for higher returns (4% yields on triple-B paper, for instance), according to Morgan Stanley.
Demand for CLOs was matched by demand for leveraged loans. With so many investors (including mutual funds) competing for collateral, CLO managers had to make do with lower-quality loans than they would have liked. According to Moody’s, 39% of leveraged loan issuance this year has been from issuers rated B3 or lower. The CLO deal rating factor (measuring the aggregate ratings of underlying loans) is considered halfway between B3- and Caa1-equivalent debt ratings, according to Moody’s.
As a result, 30% of broadly syndicated CLOs still in their reinvestment periods are failing one or more collateral quality tests. To complicate matters, managing to these tests often puts managers at odds with other tests designed to protect investors, such as the minimum weighted average spread (WAS) test measuring the cost of loans minus the coupon spread offered to investors.
Midway through the year, about 15-20% of deals were within a 10 basis point range of failing WAS tests on their deals – requiring them to adjust portfolios with more low-rated loans to push spreads wider, without upsetting the minimum collateral quality levels of deals.