Market flux drives CLO managers to test different structures

After the CLO market ground to a halt in December following a retail fund-driven loan market selloff, the primary market has at last sprung back to life, albeit with wider spreads than some issuers grew accustomed to for much of 2018 and with more varying deal structures to get investors in the door.

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“It’s nice to see the primary back online again, but the problem we’re seeing is that there’s too much supply,” said one buysider on Tuesday. “Spreads are soft and the market’s not very firm. Dealers are hesitant to take risk at the moment, so we’ve got a wide bid-ask spread, and more generally, investors can’t tell if they should be buying or selling.”

But while deals are able to inch through the pipeline, a handful of bells and whistles including shorter non-call periods and bifurcated fixed and floating tranches suggest that the market is trading softer than some participants would care to admit.

According to sources, several factors are at play are behind the move to shorter-dated paper, including greater demand from investors for medium-term exposure and bets on future financing terms from equity investors. 

“The yield curve may be too flat,” said one CLO portfolio manager. “Equity investors usually like longer deals, but some might be preferring short-dated deals currently. It’s not the reinvestment period, they’re more interested in the shorter non-call period. They’re essentially betting they can get tighter liabilities in one year versus today.”

“Even if you bought loans at 97 in 2018 when you’re earning Libor plus 3.5, going into a five-year CLO with those isn’t as attractive as forthcoming deals where loans at par are earning Libor plus 4.5,” said another buysider. “If you have a shorter structure and the entire goal is to keep the cost of liabilities low and you can price triple-As at lower levels with a shorter non-call period, that’s better for you.”

Furthermore, tighter triple-A spreads in the secondary market may also be encouraging shorter-dated deals with tighter spreads versus regular tenor deals. Based on data from Bank of America Merrill Lynch, triple-A debt in the secondary market was trading at 125bp in the week ending January 25, a figure unchanged from a week earlier. 

“We have seen secondary triple-A levels trade tighter compared to new issue markets due to shorter duration and positive convexity,” said the buysider. “That could be encouraging shorter dated paper.”

Overall, however, he expressed some confidence that new issue triple-A CLO debt may come in tighter if investment grade spreads continue to tighten as they have in the first weeks of the year.

“We’re definitely seeing that as [investment-grade] spreads tighten, the relative value of triple-A CLO becomes more attractive. And if those option-adjusted spread levels get tighter and tighter in IG credit, we think that triple-A will eventually follow suit.”

Sources have also pointed out that issuers and equity holders are increasingly permissive of deals with tranches broken into fixed and floating rate components to allow great investor participation.

Recent deals that showed this kind of bifurcation included the ‘A1’ tranche in a CLO for Wellfleet Credit Partners arranged by Mizuho and the ‘A2’ tranche of a middle market CLO from AB Private Credit Investors arranged by Natixis.

The 'A1' tranche for Wellfleet's deal consisted of a $187m 'A1A' tranche that was priced at three month Libor plus 138bps and a $13m 'A1B' tranche priced at a fixed yield of 3.99%, both of which were given a rating of Aaa from Moody's. In the middle market deal, the 'A2' tranche was split into a floating $21m 'A-2A' tranche priced at 3-month Libor plus 270bps and a fixed 'A-2B' tranche priced at fixed yield of 5.11%.

An even more recent deal from Kayne Anderson Capital Advisors exhibited bifurcation in the ‘B’ class, with $38.7m of debt in the ‘B-1’ tranche placed at 3-month Libor plus 205bps and $10m in the ‘B-2’ tranche at a fixed rate of 4.68%.

“It’s really nothing abnormal, this kind of thing happens,” said one syndicate banker on one of the transactions. “In the past, some issuers were reluctant to create a potential mismatch between the assets and liabilities, but in this particular instance, they were happy to deal with that and take the mismatch.”

One executive at a top-tier CLO manager disagreed.

“It’s generally not something you want to end up with,” he said. “The conceptual mismatch isn’t good and it has risks down the line. Better to avoid.”