Regulations Seen Holding Back CLOs in 2017 Despite Rising Demandby
Despite rising demand for floating rate loans, the market for collateralized loan obligations in the U.S. enters the New Year with daunting prospects as a new administration assumes power and risk retention rules take effect.
Factors tempering issuance include: difficulty in finding loans at a cheap price, as much of the debt is trading near or above par, potential consolidation of managers and a thin spread between what CLOs pay their investors and what they earn from underlying loans.
Projections for 2017 issuance range from as much as $75 billion to as low as $40 billion. In 2016, CLO issuance reached $71.9 billion, according to data compiled by Bloomberg, down from $98.85 billion in 2015. The market reached a peak of $124 billion in 2014, after all but disappearing after the financial crisis.
“Sentiment looks pretty good for the U.S. CLO market, although issuance will likely go down, as fewer managers will be able to issue after risk retention,” said Tracy Chen, a Philadelphia-based money manager and head of structured credit at Brandywine Global Investment Management, which oversees $70 billion. CLOs “are sitting at the sweet spot, given the potential for higher macroeconomic growth and fiscal spending next year, and the fact that it is a floating-rate product.”
Fiscal stimulus, economic growth and a steeper yield curve may bring an increase in takeovers and buyouts, possibly boosting loan supply, according to Wells Fargo & Co. Moreover, easy-money policies in Japan and Europe will boost demand for U.S. CLOs, according to JPMorgan & Co.
On the other hand, “Trump is a wild card,” said Brandywine’s Chen. If “geopolitical risk or the risk of less economic growth reappears, this will reduce CLO returns.”
But barring any unforeseen macroeconomic shocks, "CLO debt offers an investor a tremendous opportunity," said Christopher Long, president and portfolio manager at Palmer Square Capital Management. Not only does CLO debt benefit in a rising rate environment, it also has minimal credit risk and can also diversify a portfolio, he said.
‘Demand Outstrips Supply’
"We believe demand outstrips supply, and spreads will continue to tighten into 2017."
Strong second-half 2016 issuance -- including an unprecedented number of refinancings and resets -- surprised market participants following a moribund start to the year. Macro volatility caused by low commodity prices, as well as CLO exposure to downgraded oil, gas and energy companies, sidelined the market for much of the first quarter.
U.S. CLO volume, excluding refinancings, plunged in the first quarter to $8.2 billion versus $31.2 billion for the same period in 2015. While the new-issue market began to recover in March, the first quarter saw the slowest pace for deal formation since 2012, according to J.P. Morgan research. The bid for BB-rated and B-rated CLO tranches were particularly impacted. As oil prices recovered and volatility decreased, issuance bounced back. November saw the highest monthly volume for new-issue CLOs of 2016, with $10.64 billion sold.
Looming ‘skin in the game’ rules somewhat dampened supply, as managers spent time exploring various funding strategies or access to third-party capital. Many managers already have risk-retention plans in place for next year, even though only 32 percent of deals issued in the second half of 2016, were risk-retention compliant, according to Wells Fargo. Risk-retention rules are a part of the Dodd-Frank Act and aim to strengthen underwriting by requiring managers to keep some skin in the game to avoid excessive risk-taking.
Fewer CLO Managers
There were 81 collateral managers who issued at least one deal in 2016, according to data compiled by Bloomberg. Still, the CLO manager base declined 17 percent in 2016, according to Morgan Stanley research.
The combination of increasing foreign demand and continued limited supply should tighten spreads modestly next year, which may improve the arbitrage for CLO formation. Additionally, risk retention is expected to bring a higher barrier to entry on the collateral-manager side, which may thin the ranks of CLO managers able to issue.
The new rules will bring more discipline in how transactions are done, says Sean Griffin, co-head of CLO banking at J.P. Morgan. As the competitive landscape changes, some managers that contemplated setting up CLOs but were put off by the competition may finally do deals.
"I would expect to see 10 to 12 new faces next year on the collateral manager side," Griffin said in a phone interview. "At the same time, sizable AAA investors have been talking about coming online for awhile now, and they are finally starting to deploy capital.”
Japanese banks have historically been the main buyers of AAA-rated CLO tranches, but Chinese and Korean banks and funds have recently participated as well, according to Moody’s Investors Service.
Given negative interest rates in many Asian countries, and the fact that banks are flush with deposits, "CLOs are in their sweet spot for maturity, risk and return," said Jim Ahern, head of structured finance ratings at Moody’s. "They are willing to take FX risk as well," although the high cost of currency swaps may dampen demand from smaller investors.
Many global financial institutions also now view CLO AAAs as a safe, secure investment that generates yield pick-up versus other AAA-rated debt, J.P. Morgan’s Griffin said.
Meanwhile, bank analysts see the CLO equity as more problematic, particularly earlier this year amid macro volatility and the prospect of risk retention. Many equity investors didn’t want to deploy capital on non-compliant deals and instead plan to save it for compliant transactions.
The difficulty of sourcing loans has also been an ongoing concern for the manager community that may limit supply next year. "The big driver of volume is not whether managers can print deals or not, as there is plenty of liquidity, but the challenge is sourcing assets," said Moody’s Ahern.
Another potential headwind is the deteriorating average credit quality of CLOs at origination compared to a few years ago.
The underlying credit quality can halt volume, and it has tempered the market a bit, he noted. "There’s a breaking point in terms of credit quality when the growth cycle is slowing," Ahern said. "Credit issues -- such as the oil, gas, and energy issues from earlier this year -- are an indication to managers to pay attention to what they’re underwriting."