CLOs: can the market handle the heat?
US CLO deals are flooding into the market at a record pace, stretching bankers, lawyers and rating agencies to the limit and challenging the capacity of investors to absorb the heavy volume. There are no signs of slowing down but the oversupply of deals, alongside refinancings and resets, might eventually weigh on spreads, increase manager tiers and cause indigestion.
The US CLO market has recovered faster from the coronavirus crisis than expected and its performance is driving record issuance volumes. Around $75bn of new issue deals had been priced by June, meaning volumes are well on track to hit the $140bn annual issuance predicted by Bank of America. Meanwhile, spreads on triple-A senior notes were hovering between 110bp and 120bp in early July whereas they were breaking through the 200bp mark at the height at the crisis last year.
Repricing activity has boomed as well, with a robust pipeline as more managers seek to lower the costs of deals priced at wide spreads during the peak crisis months and in previous years.
Refi and reset activity was, understandably, low last year with just $31bn in 2020 and $43bn in 2019, according to Deutsche Bank.
But the strong market conditions to rework deals issued during the pandemic, and also those in 2019 and 2018 when spreads were higher, have pushed reset and refi volumes to $129bn, on target to reach Deutsche Bank’s full year predictions of $240bn.
A banner year for CLOs
The attractiveness of spreads is driving the rush, potentially challenging the market infrastructure’s capacity with participants such as arrangers, rating agencies, lawyers and even trustees under stress.
Standard & Poor’s, in a note in early in June, said that given the unprecedented CLO volumes “we are taking steps to manage the increase in demand and are working to expand our resourcing accordingly”.
Highlighting just how busy the market is, the rating agency added that it was addressing “hiring and training needs” and would only accept new grading engagements over the summer and possibly beyond, if it had the “resources and capacity necessary to provide the highest quality ratings.”
The heavy volumes since the beginning of the year can also be partly explained by the product’s resiliency — investors, some new to the asset class, have seen how well the product has coped with the crisis and have become convinced, or more convinced, of its appeal.
The CLO sector, once considered a niche in securitization, is becoming mainstream, with the total market volumes sitting at $780bn, according to Bank of America, an increase of 15% since 2019. Relatively high yields and the product’s structure have been key drivers.
“With the Covid-19 pandemic, CLOs have once again proven to be resilient in the face of credit market dislocations,” said Hsiang Lim, global head of CLO new issues at Deutsche Bank. “And in a low interest rate environment, the floating rate assets coupled with the prevalence of Libor floors, offers an attractive inflation-hedged return for investors in a world where higher yielding assets can be more scarce. As the CLO asset class continues to gain acceptance with newer investors, we see scope for further expansion and are committed to growing our share of this market.”
Managers go big
Even though senior spreads have softened recently, after being very tight in the spring when triple-A notes were sold around 110bp, new deals, including extra-large ones, are set to continue.
“From the spring to now [mid-June], CLO arb levels have contracted from excellent to decent levels, as liability spreads have widened from around 100bp at the tights to mid-teens levels today, while loan spreads have tightened by around 10bp,” says Scott Macklin, AllianceBernstein’s director of leveraged loans. “Still, we believe overall CLO creation levels remain constructive.”
After disappearing from the market following disruption caused by the Covid crisis, large new deals as well as repricings have returned, driven by demand and tighter spreads. Some managers have preferred to print bigger single deals rather than do a series of smaller deals so as to lock in low spreads.
At the beginning of February, MidCap Financial Services, a middle-market focused CLO manager owned by Apollo Global Management, reset a $1.2bn deal, achieving much tighter pricing. In March Antares Capital reset its $2.1bn middle-market CLO, originally issued in 2017, while a few weeks later Elmwood Asset Management reset a $913m CLO from 2019. Both were able to lower their costs sharply.
These were followed by the largest new issue CLO of the year so far. In June, Palmer Square Capital Management priced its first $1bn CLO (PSTAT 2021-3), arranged by Citi, and with no reinvestment period.
In line with previous Palmer Square CLOs, the transaction had a static structure with no reinvestment period and no call option in the first year. The shorter duration allowed the Kansas-based manager to sell senior notes at an incredibly tight level — the deal’s triple-A $680m tranche was sold at 80bp over three month Libor, well below the common pricing of an actively managed CLO at the time.
According to the firm run by CEO Chris Long, the size of the deal was driven by institutional demand for short duration debt with attractive relative yields, but also by “an uptick in demand for static CLO equity from family office, high net worth, and wealth management investors seeking high cash-on-cash returns.”
PSTAT 2021-3 was static in nature, where the underlying portfolio of assets remains the same as opposed to actively managed deals, in which the manager has four to six years to continue to reinvest and rejig the portfolio.
More US, less Japanese
The prolonged positive momentum on spreads and attractive equity arbitrage are driving a boom in new CLO warehouse formation, with banks competing to offer attractive terms and managers keen to open warehouses to accumulate assets and securitize CLOs.
A June US Bank report highlighted the impressive volume of active warehouses, with 108 facilities open. That 108 included a net increase of 14 new warehouses from May.
While US Bank tracks 108, other market participants believe there are more facilities in existence — perhaps as many as 200. The blistering pace of CLO formation is set to continue into the second half of the year.
“Ultimately, CLO creation is dependent on being able to create an attractive structure for the equity, so if loan availability declines, making it more difficult to source collateral for CLOs, and if the so-called arb contracts meaningfully, then CLO creation will slow, putting upward pressure on loan spreads and downward pressure on CLO spreads until the arb is attractive again,” said Macklin. “As a result, the outlook for CLO issuance will be heavily dependent on underlying loan issuance volumes and arb levels. Insofar as net loan issuance remains robust, and investor demand for CLO liabilities remains strong, both of which appear likely, we, in turn, expect heavy CLO issuance to continue.”
Plentiful supply has made investors more selective and able to pick more established issuers leaving behind smaller managers.
Despite constant market chatter about potential consolidation among CLO managers, mergers have yet to happen. On the other side, more managers are coming into the market, pushed by the strong appetite for CLO liabilities in the low interest environment.
Diameter Capital Partners priced its debut CLO at the end of June after $250m seed funding from alternative asset managers Apollo Global Management, Corbin Capital and the pension fund of renewable energy company Babcock & Wilcox.
Hedge fund Sancus Capital Management became a CLO issuer after eight years spent investing in CLO equity and mezzanine. Pacific & Plains Capital, another newly formed CLO business, is also expected to join the list of CLO managers with a first deal on the horizon.
Meanwhile, the strong appetite for CLO paper has shifted the behaviour of more conservative investors.
Some pension funds have started investing in the riskier parts of the CLO capital stack in search of extra yields, attracted by the risk-adjusted returns offered by CLO equity and mezz compared with other fixed income asset classes.
Rhode Island Employees’ Retirement System in June allocated $250m to Sycamore Tree and Neuberger Berman to invest in CLO equity and mezzanine tranches.
The State of Michigan Retirement System, Indiana Public Retirement System and New York State Common Retirement Fund have also partially allocated to CLO equity tranches and mezz debt.
The increase in the CLO market size has come about with increased participation from money managers, insurance companies and banks as well. US banks’ holdings are around $120bn, notes Bank of America, a 20% increase for the last quarter of 2020.
The triple-A space, however, is still missing its once-dominant Japanese investors.
Norinchukin Bank and Japan Post had taken a step back from the market before the pandemic hit, following the Japanese domestic regulator voicing concerns over the surge in holdings of senior CLO debt by some of its institutions. However, Japanese investors remain large holders of CLO bonds with $100bn of US CLOs collectively, according to Bank of America.
Whether or not their absence is temporary or permanent, the CLO market’s growth this year is proof that it can expand and diversify without them — a sign that market participants believe bodes well for the product’s future.GC