NEW YORK (LPC) - Issuance of US Collateralized Loan Obligation (CLO) funds is poised to set a new record and banks are getting ready for another strong year in 2019 as floating-rate loans remain in demand in a rising interest rate environment.
More than US$121bn of US CLOs have been raised as of November 23, just behind the all-time high of US$123.6bn in 2014, according to LPC Collateral data. An additional US$146bn of CLOs have been reset, refinanced or reissued in 2018 to date.
Banks expect that momentum to continue next year and are anticipating that up to US$135bn of US CLOs will be printed in 2019 despite increased scrutiny of their underlying investments.
(Graphic: CLO Issuance - tmsnrt.rs/2Q0KeYx)
CLOs are the biggest buyers of leveraged loans and investor demand is strong as the asset class has delivered positive returns this year and also offers a hedge against rising rates. The Federal Reserve (Fed) has hiked rates eight times in the last three years and a ninth increase is expected in December.
Sustained issuance in the US$579bn US CLO market could, however, be hamstrung by unattractive economics and mounting criticism of the US$1.1trn leveraged loan asset class by regulators and lawmakers.
Fed Chair Jerome Powell said on Wednesday that credit underwriting quality has deteriorated and leverage multiples have increased, which would weigh on highly leveraged borrowers if the economy faced a downturn and lead to higher-than-expected losses.
But those losses are “unlikely to pose a threat to the safety and soundness of the institutions at the core of the system,” he said. Instead they will fall on investors including CLOs that “present little threat of damaging fire sales.”
His comments follow increasing criticism of the leveraged loan and CLO markets from Powell’s predecessor Janet Yellen, the Bank of England, US Senator Elizabeth Warren and the International Monetary Fund.
The CLO market, which performed well during 2008’s credit crisis, was boosted by regulators earlier this year when CLOs were made exempt from a Dodd-Frank risk-retention requirement that forced managers to hold some of their funds. The decision opened the door to increased issuance by allowing firms to access the market that previously lacked the required capital for retention.
The US Court of Appeals for the District of Columbia Circuit, including Supreme Court justice Brett Kavanaugh, ruled in February that CLOs backed by broadly syndicated loans do not need to comply with ‘skin in the game’ rules that were intended to align investor and manager interests. Regulators did not appeal the decision.
The court ruling “has been a game changer for the ease of execution of deals,” said Paul St. Lawrence, a partner at law firm Cleary Gottlieb Steen & Hamilton. “All the major market participants are comfortable that there are ways to do all the (CLOs) they want …without accidentally triggering risk-retention rules.”
But the strength of the market could hinder future issuance. CLO spreads have widened due to a glut of new funds and a finite set of investors, which is making the economics less attractive to buyers of the most junior portion of the funds, the equity slice, who are paid last with the interest leftover after all debtholders are paid.
Spreads on the senior Triple A CLO tranche widened 2bp in October to an average 119bp from an average of 107bp in June, according to LPC Collateral.
Widening spreads have exacerbated dwindling interest payments. US companies refinanced more than US$246bn of loans in the first nine months of the year, to cut borrowing costs, and also switched to shorter-dated benchmark rates. This cut interest payments to CLOs that still have to make high payments to their own investors.
Although the arbitrage remains challenging, banks are expecting another strong year in 2019. Wells Fargo, Deutsche Bank and Nomura are predicting US$110bn of US CLO volume, while Barclays is forecasting US$100bn-US$110bn of new US broadly-syndicated CLOs and US$15bn-US$20bn of middle-market CLOs next year. JP Morgan is expecting US$135bn of issuance and Morgan Stanley is predicting US$90bn.
“We do anticipate that if CLO arbitrage (improves), it is possible we will continue to have strong issuance” next year, said Laila Kollmorgen, a managing director at PineBridge Investments.
Morgan Stanley is expecting spreads on Triple A tranches to widen in 2019 by 15bp to 135bp and spreads on BBB CLO tranches to widen by 100bp to 400bp, according to a report on Tuesday.
To close the gap on any interest shortfall, CLO managers may need to add riskier loans with higher coupons or middle-market loans to boost equity returns, Kollmorgen said.