The last few months of 2016 were a flurry of activity for the CLO market as managers rushed to issue new deals, or refinance existing ones, before rules requiring them to keep “skin in the game” take effect.
They must hold on to 5% of the economic risk of deals completed after Dec. 23. That’s a tall order for firms that acquire, rather than originate, the corporate loans that they securitize and have little balance sheet of their own. The CLO industry actually got an early start tackling this requirement. Once the final rule was announced, on Dec. 24, 2014, it became difficult for managers to raise money unless they could demonstrate to investors that they had a strategy to comply.
But even with a compliance strategy in place, there was every incentive to issue as many new deals, and extend as many existing ones, as possible in advance of the requirement. In the month of November more than 40 deals totaling $19 billion priced. That was nearly 20% of the volume of the $90.1 billion completed in the first 11 months of the year. December has been just as busy.
The question is, after such a busy period, is there any oxygen left in the room for issuance in January?
“We do believe the beginning of the first quarter would probably be slow because of the pull forward effect that risk retention was partially responsible for in this last quarter of 2016,” said Al Remeza, assistant managing director in structured finance at Moody’s Investors Service, .
Even though there is a general reluctance to serve as a trial balloon for the new regulation, however, Remaza thinks issuance is unlikely to pause altogether. That’s because of strong demand for CLOs, in particular from investors in Europe and Japan, where interest rates are in negative territory.
Indeed, J.P. Morgan reports that nearly half of the notional value of CLOs sold in 2016 went to overseas investor. Like Moody’s, it expects this to continue. As of late November, analyst at banks and rating agencies were calling for gross issuance (net of refinancing and rate resets) in the range of $50 billion to $70 billion for 2017 as a whole. That would represent a decline from 2016, but it would still make CLOs one of the biggest asset classes in structured finance.
The firm expects yield spreads on triple-A rated tranches to tighten by an additional 20 basis points in 2017, to 135 basis points over Libor, due to lower supply, lesser refi/reset loan activity, and higher prevailing interest rates.
“With new issue levels suppressed by risk retention regs, all things being equal one would expect to see loan yields propped up or rise,” says John Thacker, the Chicago-based chief credit officer and senior managing director for asset management firm Crestline Denali Capital, a longtime CLO issuer. “However, retail funds flows, [merger and acquisition] activity and leveraged loan new issuance rates will also impact on the market.”
In addition to regulatory compliance, managers will also have to grapple with some deterioration in the credit quality of assets. Moody’s is concerned about the increased indebtedness of below investment grade companies and the use of covenant-lite structures in loans. The rating agency notes that the percentage of lower-rated ‘B3’ companies accounted for 29% of the speculative-grade universe in the third quarter, up from 20% in the second quarter and 9% in the first quarter.
Moody’s expects that managers may seek additional flexibility to manage this risk.
There’s been plenty of speculation about potential regulatory relief under the incoming Trump Administration. Some players are particularly hopeful that they could regain the ability to invest in high yield bonds. Under the Volcker Rule, this puts senior securities issued by CLOs off limits to banks.
However, “any significant modification would be subject to the formal review process which would take considerable time to work through,” and “outright repeal” seems unlikely due to the Republican’s lack of a 60-vote threshold in the U.S. Senate, according to Thacker.
“On risk retention, even a repeal of the U.S. reg would still leave the E.U. rule in place for a CLO sponsor that wants to avail itself to European investors,” he said. “In short, we expect the regulatory framework in existence now to persist for at least the near term.”