Improved arbitrage is no panacea for CLOs

Optimists make a case that conditions for CLO issuance are improving. There are two main arguments that those who prefer to think that the glass is half full can point to. The first is that the fundamentals for corporate credit are excellent – and that they are unlikely to be affected by the troubles affecting sub-prime mortgages and the wider consumer credit sector.

“People have to make their own minds up, but it does seem as if there is a disconnect between the perception [of consumer to corporate contagion] and reality [that corporate fundamentals are very different],” said Kathy Sutherland, head of European CDOs at JPMorgan.

In Europe, in particular, the climate for corporate credit is as good as it has been for years – despite the recent widening of loan pricing. “This retrenchment is usually associated with an impending recession, but today we expect the growth of European GDP to continue,” said Alfred Haslinger, portfolio manager at Alegra Capital.

First-quarter GDP growth in the eurozone was a robust 3.1% year-on-year and German unemployment is at a 16-year low. “Normally loan repricing takes place much later in the economic cycle,” Haslinger added.

One example of loan prices widening comes from Europe’s InterGen, which was originally talked of at plus 200bp–225bp before being marked out to 250bp–275bp.

Second, it seems clear that, with the recent downturn in the credit markets, loan asset spreads have widened sufficiently to restore the arbitrage versus liabilities, which will have improved the equity IRR.

It was the pincer movement of tightening asset and widening liability spreads, which hit equity IRR, that resulted in the recent decline in European CLO issuance. But prices have now moved out to where deals should theoretically be back on the cards.

“We are now at levels that make much more sense,” said a senior CDO banker.

On the other side of the argument, those who are pessimistic about the prospects for CLO issuance think that the enormous overhang of announced and pending LBOs will increasingly drag on issuance.

A Barings research comment released late last Friday said: “What spread-widening we have seen may even have been due to factors almost wholly independent of sub-prime. It may instead be due to the tidal wave of issuance that the debt markets can see coming out of private equity LBO-mania. We count over US$500bn worth of incomplete cash-financed LBOs.”

Barclays’ analysts are also nervous. They expect “the CLO bid to wane, leading to possible turbulence in the space that could spill over into high-yield”, according to research released last week.

In the US some US$127bn of LBOs have been announced since mid-June and US$200bn to US$250bn are slated in the next six to nine months from such names as First Data, Cablevision, Harrah’s Entertainment, TXU Corp, Clear Communications and Tribune Company.

In Europe all eyes are on KKR/Boots, which many players say will determine future sentiment. As this could well be pulled, the omens do not look that promising (see Loans section for more details).

Paradoxically, bankers say that one of the main reasons that the KKR/Boots deal seems to have come unstuck is that there is now less demand from CLO vehicles, and as such, underwriting banks are overexposed in a market that is moving against them.

With the market finally moving in their favour, investors are happy to ride it out and see where liability spreads end up. And those on the buyside are not convinced that the improved arbitrage will really help CLO managers.

Many vehicles have been ramping-up for several months, which means they would have bought Term B and C loans at weighted average spreads of 250bp or below. So even if asset spreads widened to plus 275bp or more, which some expect, the weighted average portfolio spread could still be too tight to make the CLO arbitrage work.

“What are managers going to do with the loans that are already warehoused at spreads below 250bp?” one buysider asked. While the warehouse is likely to be hedged, it is unlikely to be a perfect hedge, he continued. “I doubt they’ll give the hedge to write down the portfolio, and in any case if you have bought protection you need an agreement that you can crystallise [to exit the hedge], and in many cases that’s not going to be possible.”

Some observers note that bankers have been asked by managers to take loans, which had been formally warehoused for CLO issuance and are now presumably out of the money, back onto the bank’s balance sheet. This would in effect clear the way for more CLO issuance as managers would then be able to ramp-up all assets at the currently wider spread levels, enabling attractive arbitrage versus liabilities.

Another CLO investor added that the inability of the market to price for CLO seasoning was deterring him from buying new product. “No investor wants to sell at these levels and traders don’t want to bid,” he said. “Why would you sell a CLO that was fully ramped in 2006, has better collateral, but which trades points below par – only to reinvest in a new issue with worse collateral at par?”

Newer CLOs tend to be more weakly structured, with the underlying loans characterised by less investor-friendly features. “You are giving away optionality and duration convexity,” the buysider said. He went on to note that the lack of real pricing action meant that there was little in the way of clear pricing points, adding to his reluctance to step in.

So while margins have improved, the CLO picture remains muddied. And with that, arrangers are deferring pricing to the year-end if they can. Even that, though, is a risky strategy: another investor predicted a “bloodbath”, as managers and arrangers crowd the market to beat year-end deadlines.