Putting the L in CLOs Gets Tougher as New Loan Supply WanesBy
Leveraged loans may not grow fast enough to meet demand
A shortage could open the door to including riskier loans
Wall Street can’t get enough of leveraged loans. No, really, there might not be enough to go around.
The shortage could temper sales this year of Wall Street’s hottest debt instrument, collateralized loan obligations, which are stuffed with leveraged loans typically used to finance takeovers. The problem: The universe of outstanding leveraged loans grew by $74 billion last year, while sales of new CLOs are projected to rise in 2018 to a record $140 billion.
“The most important question for CLOs right now is sourcing collateral,” said John Fraser, head of Investcorp Credit Management U.S., with $11.5 billion of CLOs and leveraged loan assets under management. “Can it be done at prices and spreads and risk profiles that are appropriate? That’s the big challenge.”
CLOs buy some 60 percent of leveraged loans obtained by corporate America, a near $1 trillion market of debt. If there aren’t enough loans to go around, underwriters may not be able to put together as many of those structured securities. The CLOs that do get sold may be backed by riskier loans from smaller borrowers. Investors who have been gorging on credit risk for the last decade may find themselves even more vulnerable to an economic downturn.
Forecasts for CLO sales are so bullish because investors crave yield, and CLO debt is pegged to Libor, meaning that it benefits as rates rises. The industry got another boost Friday when a court ruled CLO managers are exempt from post-crisis curbs on risk that made it harder to assemble the securities.
The pace of new loans has also been furious, but most of those deals involve borrowers who are repricing existing loans to cut interest costs, rather than fresh debt that would add to the supply.
Already, some CLO managers are finding it takes more time to line up and buy assets for their portfolios, a process known as warehousing and ramping up, according to Oliver Wriedt, co-chief executive officer at CIFC LLC, a CLO manager and investor who also expects recent tax changes in the U.S. and confidence in the economy will drive M&A and create loan fodder.
“‘The evidence of the scarcity of quality collateral is really in the fact that top-tier managers are ramping longer and longer,” he said. “It has become more difficult to aggregate attractively priced collateral.”
To be sure, CLOs can also purchase loans in the secondary market where they’re traded, according to Lauren Basmadjian, a portfolio manager at Octagon Credit Investors. Still, prices in that market hit a multi-year high this month.
“There are plenty of options in the secondary market," she said. "The loan market is big enough and liquid enough. It’s a question of whether you find the right value and price."
Finding enough assets was the biggest concern among 50 CLO market players surveyed by JPMorgan Chase & Co. in research published January. Any dearth could result in deal documents that allow loans from smaller firms, the bank’s analysts said. CLOs are also starting to last longer, adding to the pressure on supply.
“There’s no doubt that because of high demand for new issue leveraged loans, you’re seeing managers looking down the liquidity scale in underlying collateral to gain spread,” said Rob Kinderman, managing director at Ellington Management Group. “If there’s not enough collateral in the existing box, the more likely course is that other collateral types will start to find their way into CLOs to meet demand.”
CLOs buy leveraged loans and repackage them into securities for sale to investors. They work by arbitraging the crucial gap between the cash the loans throw off and the cost of borrowing for the CLO manager.
The loan repricing frenzy has worn down the cash the loans throw off. Ordinarily, that would shrink the opportunity to arbitrage the gap, and imperil returns to the equity holders, who stand last in the queue for payouts. For now, demand for CLOs from investors has been so strong that the cost of paying them has fallen in step.
“If loan spreads keep compressing and liabilities fail to keep up, the arbitrage will deteriorate and ultimately equity investors will say that it’s not the investment for us,” Investcorp’s Fraser said.
The unabated demand helped break a psychological barrier this week. One new CLO’s highest-ranking tranches priced at below 100 basis points over Libor, the first time that’s happened in the post-crisis period. One factor was that the CLO has a shorter reinvestment period, meaning investors require less compensation.
“The real problem is ramp risk in CLOs and finding collateral,” said Neil Desai, a portfolio manager at Highland Capital Management. “That could hurt.”
— With assistance by Sridhar Natarajan, and Lisa Lee