NEW YORK (LPC) - The flurry of new Collateralized Loan Obligation (CLO) issuance that followed a court decision to exempt such funds from risk-retention rules has started squeezing investor returns as spreads widen.
Spreads on the most senior tranche of US CLOs, the Triple A slice, have widened about 10-15bp in the last month. Meanwhile, spreads lower down the capital structure, on the BBB rated tranches, have seen even more pronounced change, moving about 60bp since the end of last year, according to Deutsche Bank.
The market has been inundated with new funds as managers seek to take advantage of a February Appeals Court ruling that said CLOs are exempt from Dodd-Frank risk-retention rules that require managers to hold 5% of their funds. Eliminating that requirement has opened the market to investment firms that previously did not have the capital to comply.
But a plethora of supply is testing the limits of the market and the depth of its investor base. As interest payments to CLO debtholders increase, distributions left for investors in the most junior tranche of the fund, the equity, are squeezed as they are paid last with the remaining interest, which may weigh on issuance.
There has been US$36.7bn of US CLOs issued this year through April 13, up 66% from the same period in 2017, according to Thomson Reuters LPC Collateral data. Another US$43.7bn of US CLOs have been reworked during the same period.
“With CLO issuance running well above last year’s pace we are finally seeing pushback from investors on levels considering the glut of supply,” Brad Rogoff, head of credit strategy at Barclays, said in an e-mail.
CLOs, the largest buyer of leveraged loans, sell tranches of varying risk to investors backed by a pool of loans made to large US companies and are a crucial funding source for borrowers to refinance existing debt and fund acquisitions.
Both CLOs and leveraged loans pay investors a coupon plus the London interbank offered rate (Libor), so as rates rise, so do holders’ interest payments, offering an ideal investment in a rising-rate environment. The Federal Reserve has increased rates six times since December 2015 and Bank of America Merrill Lynch is expecting two more hikes this year.
FEELING THE PINCH
The court ruling has opened the door for smaller managers to refinance or reset existing deals they previously could not rework. A lack of new loan supply has also supported a surge in CLO resets as managers look to keep existing funds in place longer.
A record US$923.78bn of US institutional leveraged loans was arranged in 2017, but the majority, US$503.23bn, was refinancings, not new supply, according to LPC data. In the first quarter US$123.61bn of US$185.47bn of volume was refinancings.
In a CLO reset, the original deal, including the loans it owns, remains in place and its reinvestment period and maturity are typically extended to allow the fund to remain outstanding longer. Increasing the reinvestment period allows the fund to purchase new loans for a longer period of time. In a refinancing, the tenor of the vehicle typically remains the same while the interest rate paid to investors is cut.
More resets may be on the way as another US$34bn of 2015 and 2016 CLOs have already exited their non-call period, the timeframe in which a fund must remain outstanding, or will this quarter – prime candidates to be reworked. Another US$46bn of CLOs will be eligible in the second half of the year, according to an April 18 Deutsche Bank report.
This could mean more pain for CLO equity holders who receive distributions with whatever interest is remaining after all of the funds’ debtholders are paid. Equity payments are already under pressure as companies seek to cut borrowing costs by switching to a cheaper short-term Libor rate to set their loan interest payments.
Three-month Libor was 2.361% on Thursday, compared to one-month Libor of 1.898%.
The switch to one-month Libor could cut equity returns by 0.2-3%, according to Citigroup.