CORRECTED-Lack of loans not the only problem for European CLOs
(Corrects name in tenth paragraph to Robinson)
* Dearth of new assets not only hurdle to new European CLOs
* Legacy CLO spreads' gap to new issue levels stymies refis
* More US CLO calls anticipated this year
By Anil Mayre
LONDON, March 1 (IFR) - Portfolio managers' hopes of reviving the fledgling European CLO market are hamstrung not only by a lack of new supply of loans to provide collateral, but also limited refinancing opportunities due to a dearth of issuance in 2009-2011.
This is in contrast to the US, where refinancings are common - 3i for example took out its Fraser Sullivan CLO V deal with a new transaction that closed this week. In 2012, US CLO issuance surpassed USD50bn, matching volumes last seen in 2005, and this year could be better still.
Market participants have long discussed the comparative ease with which US managers can source collateral, typically within a few days versus many weeks in Europe, but they can also refinance existing post-crisis deals that printed with high coupons in new, more tightly priced "CLO 2.0" structures.
Analysts at Credit Suisse recently said they expected all US deals launched in 2010 to be called this year as a result.
For an equity holder, forcing the call in the current environment makes sense. A deal that priced at Libor plus 180bp in 2010, for instance, needs more of the cash within the structure to service liabilities than one where the Triple As pay low 100bp - which is possible in the current US market.
In the last week both ACAS CLO 2013-1 and Fortress Credit BSL priced their Triple As at 118bp, CIFC Funding 2013-I came at 115bp, Figueroa 2013-I at 125bp, ING IM CLO 2013-1 at 114bp and Dryden XXVI Senior Loan Fund at 110bp.
But in Europe the dynamic for refinancing does not work, with current spreads much wider than the previous batch of issuance.
That batch are pre-crisis deals which were clearing in the mid 20bp area over Euribor. Only one typical CLO (excluding a refinancing of legacy books such as ECG EOS or ECAS trades) has priced since - Cairn CLO III at 140bp.
So it makes little sense for European CLO equity holders to exercise call options to refinance because any new issue would price substantially wider.
"Equity holders in the US will look at what new issue spreads they can get and whether that is tighter than the current structure. In Europe, from a refinancing point of view, there is no real juice in the structure," said Ian Robinson, partner at fixed income advisory and risk management firm Kinson Capital.
"Cairn priced at 140bp, but as 2006/2007 deals priced around 23bp, the cost of debt in the old deals is lower than it would cost to refinance today," he said.
The US market has enjoyed more of a rally in both underlying loan assets and liabilities. And while narrowing loan spreads can reduce equity payouts, the rate at which the bond liabilities have tightened helps balance the equation.
"The incentive for equity tranche investors to exercise optional redemptions will now be higher," said Morgan Stanley analysts.
FAILING THE OC TEST
Another factor restricting refinancing potential is the overcollateralisation (OC) test which measures the values of CLO assets versus liabilities.
Bank of America Merrill Lynch analysts said at the start of February that over 40% of European CLOs were failing their junior OC tests - which then diverts cash to the senior notes away from junior tranches - and that many more were close to breaching the test too.
Lower loan prices inhibit a deal's structure to ensure the bonds can be repaid, which impacts the ability to call a deal.
"The market value of assets is in general higher than what we have here, it is not yet at the level where equity can be repaid," said Emanuele Tamburrano, director in S&P's CDO team.
This valuation is a major factor in determining a deal's outcome.
"When unwinding a deal the prerequisite is to pay back the rated debt at par, but a lot of deals can't do that so there is low value to equity of exercising the call," said Robinson.
Bank of America Merrill Lynch analysts explained in a another note that some managers showed annualised cash returns of close to 20%, but others showed little or no equity payouts because their deals were severely undercollateralised.
Nor will the ability to issue newly-styled deals with conservative formats be a factor: Cairn for example was five-times leveraged against the pre-crisis norm of ten.
"The advantages of CLO 2.0 are cleaner structures, lower fees and more flexibility, but 100bp is a lot to make up for," said Robinson.
PRAMERICA EYES BONDS
Cairn's EUR300m deal targeted 90% senior secured loans and was 50% ramped up, but it has a six month period left to source the remaining collateral.
The follow-up trade, expected to be Pramerica via Barclays, on the other hand, is said to allow for a much larger proportion of bonds in the pool. This approach could allow managers to load up their portfolios with loan-substitutes, but they would have to be in secured format which are treated as being close to loans in terms of seniority, another CLO official said.
"We have seen increased issuance of high yield bonds, and we expect these to find their way into structures," a senior structured credit rating analyst said.
"It will depend on the manager's approach to a traditional view of assets, as they could move away from the 90-95% senior secured loans and push the limit of investment criteria to get the deal away," he added. (Reporting by Anil Mayre, editing by Alex Chambers, Julian Baker)
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