The past year has been a good one for collateralized loan obligations. Issuance has been way up while deals that have been around for a few years have had the benefit of being in a loan market where there has been tremendous price appreciation and few defaults. But the very success of the past few years may create problems down the road, market players said.
"The current market conditions create a catch 22," said Shin Yukawa, an associate director at Fitch Ratings. "Any time the business environment improves over a prolonged period, the loan market becomes a borrower market, where spreads come in, multiples rise and documentation becomes less restrictive. However, for a CLO, this positive environment creates an asset class that is less appealing because less relative spread means less room for error. Any future defaults or trading losses will have to be supported by less excess spread, which increases the CLO's sensitivity to these negative events," he added.
The CLOs being structured today face a much more challenging environment, he said. Tight spreads, above-par market values and tough allocations in the primary market have made the structuring and ramp-up of CLOs more challenging. "Investors are also keenly aware of rising debt multiples and less favorable covenants that come with every credit cycle and are watching the asset class very carefully to prepare for a potential down cycle in the future," Yukawa continued.
However, on the positive side, CLO liability spreads have also come in, which has helped the vehicles maintain relative spread balance between the assets and liabilities, he noted. For instance, last week Nomura Corporate Research and Asset Management raised the $300 million Clydesdale Strategic CLO with pricing of LIBOR plus 31 on the AAA tranche. At the beginning of this year spreads on AAA tranches were north of LIBOR plus 50 basis points. J.P. Morgan even argues in a recent report that AAA CLO spreads could tighten to LIBOR plus 26-29 by the middle of next year.