Recent leveraged loan spread widening could be a boon to new-issue CLO investors - as long as the widening is in fact due to market technicals. Bear Stearns analysts said as much last week, pointing out that widening in leveraged loan spreads could be owed mainly to supply and demand mismatches. On the fringes, some of the pull-back among certain investors could be due to loosened loan covenants, analysts said. But credit fundamentals within the U.S. loan market are widely anticipated to remain strong for several years - opening the door for equity investors to take ample opportunity of the record high return-on-equity in the space.
As projected CLO equity returns continue to rise, the deals show "value at the wings," JPMorgan Securities analysts wrote last week. They said CLO spreads appear to be standing their ground, although double-A and triple-B tranches could be weakening. Estimated U.S. CLO return on equity was at 16% as of last week - a two-year high, JPMorgan said. "Given [the] lack of significant widening in HEL ABS spreads, CLO equity now offers higher returns than modeled SF CDO returns ... which is attractive given fundamental credit trends," analysts stated, adding that mezzanine structured finance equity is producing an ROE in the low to midteens. Analysts expect warehousing CLOs, which represent a U.S. arbitrage pipeline of about $12.7 billion, and excess cash in existing CLOs will support loan spreads. "With CLO debt spreads near tights and HY defaults expected to remain low in the near future, CLO equity presents an increasingly attractive risk-reward outlook," they wrote.
The U.S. CLO sector seems to be holding its own within the overall growth surge within the wider CDO market. According to Bear Stearns, anecdotal evidence indicates CLO issuance was nearly $43.5 billion in the first half of 2006 - almost twice the issuance in the same time period last year and about $10 billion less than all issuance in 2005. The leveraged loan pipeline was surging at record levels by the end of July, with more than $70 billion in issuance. Issuance in the first half of the year totaled $244 billion - about 1.5 times the issuance seen in the first half of 2005, Bear Stearns analysts said. Similar to the ABS CDO market/RMBS cycle, CLO demand continues to feed new issuance and spread compression.
But because loan paper is available below par in the secondary market - and nearly that soon after new-issue - investors have been less prone to snatch up fresh deals, Bear Stearns stated. Average double-B and double-B minus institutional spreads widened 32 basis points by the end of the first half of the year, and as of last week were at a 13-month high of 215 basis points. Single-B and single-B plus spreads widened to a 13-month high of 284 basis points, according to Bear. Widening CLO asset spreads is beneficial to both new-issue CLO equity investors and investors in CLOs which are still in their reinvestment periods. "If the current spread widening continues without any external shock to the economy, then it presents a good relative value opportunity for CLO equity investors to lock in higher yields," Bear analysts wrote.
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