By Kristen Haunss
NEW YORK, Dec 12 (LPC) - Issuance of US Collateralized Loan Obligations (CLOs) has set a new annual record, even as spreads on the funds’ most senior tranches widen and regulatory scrutiny of their underlying assets increase.
There has been US$124.6bn of US CLOs raised this year through December 7, topping the previous record of US$123.6bn set in 2014, according to LPC Collateral data. Another US$149.6bn of deals have been refinanced, reset or reissued in 2018.
Investors have turned to the US$582bn US CLO market, the largest buyers of loans, which companies including American Airlines and Callaway Golf rely on to fund their businesses and back acquisitions, as a hedge to rising rates. The funds, which pay most investors a set rate plus Libor, can be seen as an enticing investment in this environment, and a number of new investors have entered the space this year. The Federal Reserve (Fed) has hiked rates eight times in the last three years with a ninth increase expected this month.
But loans have not been immune to volatility seen the last two months in other markets, with the SMi100, which tracks the most widely held loans, dropping to 96.29 on December 11, the lowest level since March 2016, which has weighed on CLOs.
With spreads widening, some managers considered holding their CLOs until next year with the hope the volatility would decrease. But as leveraged loan prices have continued to fall, some firms decided to price their deals now in case the downward pressure continues into the New Year, according to Jason Merrill, investment specialist at Penn Mutual Asset Management.
Spreads on the most senior tranche of the funds, the Triple A slice, have widened this year to an average 120bp in November from an average of 98.14 in March, leaving less for equity holders who are paid last with the interest left over after the fund debtholders are paid, according to LPC Collateral data.
And while the debt coupons have increased, so has the Libor rate the interest payments are pegged to – three-month Libor rose 108bp this year through December 12.
But with more investors flocking to floating-rate debt, especially in the first nine months of the year, companies were able to take advantage of the demand, with borrowers refinancing US$339bn of loans in the first three quarters of 2018, paying less interest to the funds, according to LPC data.
The mismatch makes it tougher for CLOs to find collateral that managers find high enough quality with a big enough coupon, even though US$585.1bn of institutional loans were arranged through September 30, an issue that may continue into 2019. The conundrum can lead some firms to buy higher yielding but riskier credits in order to generate enough cash to pay equity investors.
Falling returns come as regulators increase their criticism of looser underwriting in the US$1.1trn US leveraged loan market.
Most recent to join the chorus of concern from former Fed Chair Janet Yellen and the Bank of England is Fed Governor Lael Brainard, who said that many of the largest banks originate loans to sell to CLOs, which may expose pipeline risk if banks have difficulty finding buyers for the debt when conditions deteriorate.
Yet despite the noise, US CLO volume is expected to be strong again in 2019. While bank analysts differ on whether a new record could be set, JP Morgan says it expects US$135bn of issuance. (Reporting by Kristen Haunss Editing by Jon Methven and Chris Mangham)