The U.S. collateralized loan obligation market is showing signs of a lull after seeing robust activity in the first half of the year, marking a substantial speed bump in a keenly anticipated recovery, according to sister service Thomson Reuters LPC, which tracks the loan market.
So far this year, $8.23 billion in CLOs have been printed in the U.S., according to Thomson Reuters LPC data. That figure brings issuance closer to the lower end of the $10-15 billion in 2011 volume that most market players had been predicting since the second quarter. But many market participants say they are now tempted to revise that forecast downward in light of the increased volatility in the broader financial markets.
“Right now, there aren’t enough debt investors out there to support CLO issuance of significantly more than $15 billion,” said a CLO manager at a large shop.
To be sure, the $10-15 billion in issuance projection would be a mere fraction of the nearly $100 billion in CLO issuance seen in the bull market of 2006. Still, the resurgence in new issue CLO deals in the past year has offered solace to the leveraged loan market, where CLOs now make up around 40-50 percent of the demand, down from 70-75 percent in 2006.
In the first half of the year, before European sovereign debt issues and concerns around the U.S. economic recovery gripped the financial markets, investors had been lining up both for CLOs’ senior-most tranches, or AAA notes, and for the equity piece.
With the economics of investing in a CLO improving since the credit crisis, returns to equity holders in new issue CLO deals this year have been marketed at 12 percent to 15 percent. And even though many CLO managers had reportedly been financing a hefty part of the equity slice on their own, market participants say that interest had been coming in from various quarters such as private equity funds.
Now, that interest is waning as the new issue CLO market succumbs to gyrations and uncertainty in the overall financial markets. And a hold-off of new issue deals such as those for Invesco, CIFC and Octagon comes at an already precarious time for the leveraged loan market. Other buyers of loans such as retail mutual funds have been exiting loans—with outflows of $1.5 billion and $261.1 million in two recent weeks—to free up cash for redemptions, underscoring just how badly the leveraged loan market needs a stable investor base.
Part of that stability could have come from a stable CLO market, sources noted. But to get there, the CLO market would need to address a few challenges of its own. While investors across the CLO capital stack have been instrumental in reviving activity this year, they continue to be few and far between. And in times of market duress, that lack of depth in demand for the CLO product can be particularly glaring.
“It’s the same guys that are investing in the AAA and the equity,” said the CLO manager. “They hold all the cards.”
CLOs package leveraged loans into different slices of risk and sell them to investors as bonds with varying yields. CLOs make money based on the difference between the liabilities spreads that they pay to their investors and the spreads they earn on the underlying loan assets. Since 2010, liabilities spreads on all parts of CLOs’ capital stacks have been trending lower, although they are still wide compared to liabilities spreads on the vintage CLOs from the bull market of 2006.
Meanwhile, loan asset spreads are wide on a historical basis and have been especially widening out in recent weeks given that the average bid on loans has dropped from 96.05 cents on the dollar to 93.23 cents on the dollar between Aug. 1 and Aug. 11. Widening loan spreads boost the spread arbitrage for CLOs and enhance returns to equity holders.
In June, AAA spreads in the secondary market lagged AAA spreads in the new issue market by around 20-25 basis points. But now that gap is even higher. AAA spreads in the secondary are currently around 220 basis points, up from 150 basis points in June, according to Citi. Meanwhile, the latest series of new issue CLO deals—including those for Babson, PineBridge, BlueMountain and GSO Blackstone—printed their AAA notes at 120-130 basis points.
“Although wider secondary spreads have put pressure on new issue, we continue to see triple-A coupons between L+120-130 bps. In addition, we continue to hear talk of several deals in the pipeline,” wrote RBS strategist Justin Pauley in an Aug. 11 research report.
For months, several shops have been rumored to be prepping new CLO vehicles but whether or not they are able to bring those deals to market in the coming months and at what terms will be eagerly watched, CLO sources said.
Meanwhile, some shops that issued CLOs in the past few months are understood to be pursuing a buying opportunity by using the recent drop in loan prices to ramp up their vehicles with assets that are now cheaper than they were when the CLOs were issued.
(Smita Madhur is a senior correspondent for Thomson Reuters LPC.)