June 27, 2019 / 5:43 PM / 4 months ago

US CLO issuance just behind 2018’s record pace despite challenges

NEW YORK, June 27 (LPC) - Issuance in the US Collateralized Loan Obligation (CLO) market is just behind the record-setting pace of 2018 despite criticism of the asset class and higher spreads eating into returns.

There has been US$63.84bn of US CLOs arranged this year through June 26, just behind the US$65.62bn arranged during the same period in 2018, according to LPC Collateral data. A record US$128.1bn was issued last year.

Issuance in the CLO market, the largest buyers in the US$1.2trn leveraged loan market that companies depend on for financing, has been steady despite criticisms likening the asset class to investments at the root of the 2008 credit crisis. Central bank policy has frozen interest rates, which has led to investors fleeing floating-rate loans.

“The first six months have seen a fairly sanguine correction in the loan market and a normalization of an issuance phase that we expect is sustainable,” said Dagmara Michalczuk, a portfolio manager at Tetragon Credit Partners.

Monthly volume this year peaked in April when US$15.7bn of the funds was arranged after a slow start in January when just US$5.12bn was issued, according to the data. The outstanding US CLO market rose to US$613bn in May, a 124% increase since January 2013.

“The first quarter, specifically, was dominated by a lot of what we would characterize as ‘cleanup issuance’ from warehouses that were potentially initiated earlier in 2018,” she said. “The second quarter of this year has seen a much healthier trend of CLO liabilities tightening.”

Volume picked up following a December selloff amid increased global volatility with loan prices – as measured by a cohort of the 100 most widely held loans – falling 2.6%.

Some managers held 2018 deals for 2019 in hopes market conditions would improve – loan prices jumped 2.5% in the first nine days of January. Other firms chose to issue funds with shorter terms to counter rising spreads.

Spreads on the largest portion of the funds, the Triple A tranche, jumped to an average 138bp in February, the highest level since January 2017, according to the data. They have slowly tightened, hitting an average of 132bp in May and a handful of CLOs priced in the 120-130bp range in June. In May 2018, the average Triple A spread was 103bp.

The wide spreads can cut into returns paid to equity holders, who are paid last after all other debtholders receive their distributions.

Triple A spreads could tighten further, but that could lead to more reset activity, and that increased supply would then pressure how much further Triple As could tighten, according to John Wright, head of Bain Capital Credit’s CLO/structured products business.

With wider CLO spreads, reset volume is just US$6.2bn, down 83% this year through the end of May compared to the same period in 2018, according to LPC Collateral.

Despite challenges, investors still see opportunities.

CLO equity is attractive and BB rated tranches as a relative value pickup compared to high-yield bonds offer an opportunity, Wright said.

“CLO BBs, where you can buy them at a 700bp discount margin with a price discount, is a pretty interesting entry point,” he said.

REGULATORY FEEDBACK

Criticism of the asset class and the underlying loan market from legislators and regulators including former Federal Reserve (Fed) Chair Janet Yellen and Mark Carney, Governor of the Bank of England, has weighed on the market.

The Financial Stability Board (FSB) told G20 leaders in a June 25 letter that it is “closely monitoring” loan and CLO markets to obtain a fuller picture of exposures to these assets globally.

The Japanese Financial Services Agency (JFSA) finalized risk-retention rules in March, which also weighed on the market. Japanese banks account for about 10% of the US$750bn global CLO market, according to a Bank of England estimate.

In the US, after nine hikes in five years, the Fed last year stopped raising rates. In response, more than US$18bn has been pulled from loan funds this year through June 19, according to Lipper. Companies pay lenders a set coupon plus Libor, so lenders are paid more when rates rise, but lose that benefit when rates are held steady.

Retail loan outflows have been offset by CLO issuance, which has helped to keep a sanguine tone in the market, Michalczuk said.

“Market tone can shift quickly in either direction so we are very focused on executing things fairly quickly and taking advantage of opportunities that we clearly think are attractive,” she said. (Reporting by Kristen Haunss. Editing by Michelle Sierra and Jon Methven)

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