Glut of CLOs drives decline in loan standards

A spike in the supply of US leveraged loans and CLOs has caused spreads to widen in both markets in recent weeks. While CLO managers are scrambling to satisfy demand for the product, critics say they should be doing more to protect the quality of the loans they are investing in.

  • By David Bell
  • 10 Jul 2018
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CLO managers are printing new deals at record pace — the $68.1bn of new deals printed through to the end of June was the biggest ever first half of the year for the market. On top of that, loan mutual funds have posted $12.3bn of inflows in the year to date.

Triple-A CLO spreads have widened by around 20bp on the back of the increased supply, which is in addition to surge of reset and reissue transactions during July.

But despite the increase, demand for loans was outstripped by supply in the second quarter of the year, with $89bn of new paper added to the S&P/LSTA index, largely on the back of an increase in mergers and acquisition activity. This marks the first time since 2016 that supply has outspaced demand in the US leveraged loan market.

Loan margins have softened as a result.

As the LSTA pointed out at the end of last week, wider CLO spreads has put pressure on the arbitrage in the deal structures, prompting managers to push harder against the tightest pricing levels in the market, which was previously in the 175bp over Libor area.

There were $23bn of loans sold at 175bp over Libor in May, but just $400m in June, the LSTA wrote.

Jon Savas, senior portfolio manager at SKY Harbor Capital Management, said that the softness in CLO spreads had prompted managers to source riskier, higher yielding collateral to improve the arbitrage in the structures.

“We haven’t seen much in the 175bp area in the last few weeks, but that could just be because there haven’t been as many highly rated loans coming to the market recently. There has clearly been a better bid for yieldier loans in the last month or two, driven by CLO managers looking to make the arbitrage work,” he said.

CLOs 'the biggest driver'

JP Morgan analysts wrote on Tuesday that single-B rated loans have delivered 2.69% of gains in the year to date, outpacing higher rated double-B loans which have offered 2.01% returns.

The trend was also seen in April, when a surge of CLO activity around the April equity payment date resulted in some spread widening that also put pressure on loan pricing.

Despite strong appetite from mutual funds and exchange-traded funds tracking leveraged loans, CLOs still account for the biggest portion of the loan investor base at around 60-65%, and CLO participation could be at a “high water mark” for the post-crisis era, according to Savas.

Given their integral position in the investor base, some buyers think that the CLO community should be doing more to prevent borrowers from getting away with overly aggressive and flexible deals.

“So much money has flowed into the loan market over the last few years,” said Michael Donoghue, president of Phoenix Investment Adviser, which manages funds that focus on deeply endebted US corporates, including distressed debt, high yield and bank loan strategies.

Donaghue said that his $300m high yield strategy included an allocation of around 15% to bank loans, mainly to benefit from floating rates.

“The biggest driver is the CLO machine — money managers are taking advantage of the fact that market is wide open, to raise substantial amounts of money. Issuers feel they are getting the upper hand more in loans than in the high yield market.”

He said that the loan market was offering borrowers far more flexibility than they were able to secure in the high yield market, despite the high yield market suffering a 28% drop in issuance compared with the same period last year.

“[High yield] investors are still being relatively judicious. A number of high yield issues have struggled, or the borrower has scrapped the bond part and gone to the loan market instead. To us, that shows there is so much money in the loan market that people just need product and they’re being less judicious about what credit they buy.”

The loan market has also however shown the ability to push back on pricing and terms in recent weeks, as supply increased.

Lawyers and covenant analysts pointed out last week that some of the more aggressive loopholes were tightened in deals during June, although the balance still seems in favour of the borrower.

  • By David Bell
  • 10 Jul 2018

Bookrunners of European Leveraged Loans

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • Today
1 BNP Paribas 11,614.39 49 7.38%
2 Credit Agricole CIB 10,789.94 46 6.85%
3 Deutsche Bank 8,986.23 33 5.71%
4 UniCredit 8,448.15 49 5.37%
5 HSBC 8,442.65 35 5.36%

Bookrunners of European HY Bonds

Rank Lead Manager Amount €m No of issues Share %
  • Last updated
  • Today
1 BNP Paribas 3,365.73 40 7.14%
2 JPMorgan 2,943.35 32 6.24%
3 Deutsche Bank 2,871.30 26 6.09%
4 Credit Suisse 2,741.05 26 5.81%
5 Goldman Sachs 2,694.50 26 5.71%

Bookrunners of Dollar Denominated HY Bonds

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • Today
1 JPMorgan 13,441.09 110 9.68%
2 Citi 10,547.56 89 7.59%
3 Goldman Sachs 9,401.85 75 6.77%
4 Bank of America Merrill Lynch 9,320.56 87 6.71%
5 Barclays 9,314.40 70 6.70%