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Bursting The ‘Bubble’ Talk: Today’s Leveraged Loan Market, By The Numbers

From stories in the popular press to dire analytical reports to pronouncements from Federal Reserve Chair Janet Yellen to statements from the OCC, a growing chorus is warning of a bubble in the leveraged loan market. Driven in part by the liquidity that (ironically) has resulted from the Fed’s zero-interest-rate/QE policy, banks and other lenders are said to be seeding the loan market with increasingly aggressive transactions and could end up reaping a bitter harvest of high defaults and stinging credit losses.

Our analysis of how far the pendulum has swung is based on hard data and is informed by conversations with loan market participants. One point on which everyone agrees: structure and terms are looser than they were earlier in the cycle, when liquidity was scarce and the economy was fragile.

Where views diverge, however, is on the question of whether we are witnessing the excesses normally associated with late-cycle booms such as those of the late 1980s (hyper leverage on thin-margin retail businesses), 1999-2000 (blueprint telecom deals), or 2006-2007 (highly leveraged, jumbo take-private LBO trades). Many market participants argue that the answer is no – or at least not yet.

To illustrate this point, the state of play in the leveraged loan market can be viewed along three broad lines:

  • Credit: Today’s loan issuers sport higher-than-average leverage multiples, but levels are well inside the peak readings of the past. However, this theme is mitigated in two ways. First, today’s low borrowing costs offset higher leverage by bolstering coverage ratios. Second, few 2014-model deals carry either the heroic leverage associated with the large-scale LBOs of 2007 or the negative out-of-the-blocks cash flow.
  • Risk/return: Though loan yields are low on an absolute basis, spreads relative to the base rate are still in the middle of the historical fairway.
  • Terms and conditions: Loan T&Cs have evolved in the post-crisis period in a way that offers issuers unprecedented optionality, most notably in the widespread use of incurrence tests and incremental tranches.

We’ll take each of these in turn.

New-issue credit profile
Large LBO deals provide a consistent gauge by which to measure the credit hygiene of the loan market. And, indeed, the average leverage ratio at which these deals have been struck has crept higher in recent quarters from the more conservative levels of 2010-2011.

At the same time, PE firms are reeling in equity contributions:

Still, what is missing from the recent mix is the large tail of highly leveraged, thin-coverage deals that were rampant in 2006/2007. This chart, for instance, shows the share of LBO deals structured at 7x-plus leverage:

In the past, such loans produced an outsized share of defaults when the cycle ultimately turned.

As well, rising leverage levels are being ameliorated by low borrowing costs, which bolster coverage ratios, as this chart illustrates:

More to the point, the super-thin-coverage deals of the 2006/2007 period are not in play. So far this year, just 2% of LBO loans had an initial ratio of EBITDA less capex to cash interest of less than 2.0x, versus 64% in 2007.

Here again, narrower coverage produced the expected spike in defaults.

Of course, some of this cushion could evaporate if interest rates spike. After all, just 14% of the average debt stack for first-half LBOs is in the form of fixed-rate bonds, and provisions that once required borrowers to hedge half of their floating-rate exposure are a relic of a bygone era, participants say. Thus, if LIBOR climbs past the average floor of 1%, issuers could be in for higher interest costs, and loans will reset higher. That said, forward three-month LIBOR doesn’t cross the 1% barrier until January 2016, according to Bloomberg, with expectations for 2% in January 2017 and 3% in April 2019. As these figures imply, the market believes it is unlikely that rising rates will crimp coverage any time soon.

Credit profile of the S&P/LSTA Index universe
By most measures, the credit profile of the loan market remains robust, despite the fact that leverage levels across the S&P/LSTA Index have climbed steady – if slowly – in recent quarters as a result of (1) record recap activity and (2) as noted above, more highly geared new-issue transactions.

Loan issuers’ ability to service debt, for instance, has improved dramatically in recent years as a result of two salutatory trends: (1) muscular EBITDA growth since the recession ended in June 2009 and (2) shrinking financing costs.

The result: fatter cash-flow-coverage multiples across the universe of S&P/LSTA Index issuers that file publicly.

While wider coverage doesn’t rule out defaults, it obviously affords issuers greater wherewithal in the event of a downturn.

Looking at rating dispersion shows a similar pattern. The share of performing S&P/LSTA Index loans outstanding that Standard & Poor’s rates CCC+ or lower climbed to a two-year high of 5.98% by June, from a five-year low of 4.19% in January. In the interim, S&P downgraded a few borrowers’ loans to triple-hook territory, including Caesars EntertainmentGymboreeEducation Management, and Auxilium. Despite the recent run-up, however, the share of CCC paper in the Index remains well inside the historical highs of 10-13%, from 2009.

Yield versus risk
Lining up the loan market’s current risk/return proposition with those of the past is a difficult exercise, given today’s historically low interest rates. In terms of absolute yields, today’s loans clearly offer a low prospective return.

In part, this situation is a product of razor-thin underlying base rates. Loan spreads, by contrast, are more generous. This chart shows the same trend but uses the discounted spread over LIBOR.

Putting this trend in context, BB Index loans offered a discounted spread of L+361, on average, as of July 11, which is 23 bps wide of the historical median level (we use median here because the heights of the dislocation skew the averages). Single-B loans, meanwhile, were at L+473, or one basis point wide.

It gets more interesting when we exclude the benefit of LIBOR floors, which many players see as a way to compensate lenders for a particularly steep yield curve, with three-month LIBOR lingering in the 0.20-0.25% range and 10-year Treasuries recently in a 2.5-2.6% band. Excluding LIBOR floors, the current BB discounted spread is L+296, 15 bps inside the long-term median, with single-Bs at L+391, or 20 bps lower.

Taken together, these metrics show that the market remains in the historical fairway between boom and bust.

Looking at the data another way, the average discounted spread of the S&P/LSTA Index was L+441 as of July 11, which implies an imputed default rate of 2.83%, outside both June’s reading of 1.08% (excluding Energy Future Holdings) and managers’ average June 2015 forecast of 1.76%.

As this chart makes plain, the margin of safety has tightened significantly in recent years in the face of robust market liquidity and consistent economic growth. That said, loans are not priced today as if there will never be another default, as was the case in late 2006/early 2007.

Documentation
Where the factors discussed above suggest a Goldilocks scenario in the loan market, the erosion in documentation protections is the poster-boy trend of the bubble brigade. Covenant-lite is the most visible example. So far this year, 62% of new institutional loans cleared with only incurrence tests, topping 2013’s prior high of 57%. As a result, a record 56% of S&P/LSTA Index loans are now covenant-lite, up from 46% at year-end 2013.

There is no doubt that managers see the proliferation of covenant-lite technology as an unfortunate outcome of today’s market liquidity. But the reason is not that covenant-lite loans are inherently more risky. In fact, the historical record shows that maintenance tests did not produce either (1) lower default rates or, more to the point, (2) lower losses given default. As reported, Energy Future Holdings’ $19.5 billion loan default, from April, pushed the 2008-to-date default experience of covenant-heavy S&P/LSTA Index loans to 19.0%, from 16.6%. By comparison, the corresponding figure for covenant-lite loans is 10.3%. Drilling down to loans that S&P initially rated single-B, the stats are similar, at 19.8% for loans with maintenance tests and 11.0% for those with incurrence tests. As for recovery rates, the average price at which defaulted incurrence-test-only loans exited bankruptcy was 70.0 cents on the dollar, versus 65.6 for loans with traditional tests.

That’s not to say that toggling from maintenance to incurrence tests is without consequence to lenders. Clearly, traditional financial covenants provide an effective repricing option for lenders when an issuer’s financial performance slides. Take the default spike 2008-2010. During that three-year period, issuers loosened tests on roughly 21% of covenanted loans that were outstanding at year-end 2007. On average, these waivers cost the borrowers in question a fee of 57 bps and 201 bps of incremental spread. Taking this calculation a step further, 86% of Index loans had maintenance tests when 2007 ended. Thus, from 2008-2010, lenders were able to increase the average spread of their legacy portfolio by 36 bps.

Apply those same statistics to today’s Index universe (44% of which is are subject to maintenance covenants), and the spread lift – based on the same pace of waivers for covenanted loans and average spread increase – would be just 19 bps.

Where covenant-lite is viewed more as a damper on future returns than a spur for higher credit losses when the cycle turns, managers do worry about the credit implications of free-and-clear incremental tranches. These provisions, which allow issuers to tap the market for additional loans unfettered by the restrictions of incurrence tests, have become a pervasive feature of newly minted covenant-lite loans over the past 18 months. Some parameters:

An anecdotal scan of recent deals shows that the vast majority of covenant-lite loans have an incremental carve-out under incurrence tests that allow issuers to add another turn, give or take, of fresh loans outside the scope of the covenant. In LCD’s review of the data, 2014 covenant-lite loans allowed free-and-clear tranches equal to 0.96x pro forma EBITDA.

The lenders have some protection, in that with rare exception – Gates Global being a notable recent example – loans are fortified with most-favored-nation provisions that do not sunset and therefore provide pricing protection for the life of the loan. So far this year, the average MFN is 50 bps. Moreover, managers have scored small victories by pushing back against excessively large incremental amounts. Recent examples include Vantiv, which scaled back its free-and-clear limit to $650 million, from $800 million; Phillips Medisize (to $80 million, from $100 million); and Nextgen (to $65 million, from $80 million).

Still, credit vigilantes worry that in an extreme case an issuer could raise an incremental tranche at some high rate to pay a dividend, thereby allowing a PE firm to get some (or all) of its bait back while lenders are left with a less creditworthy debtor vulnerable to default. Another potential downside risk: struggling issuers might use incremental tranches to effect a distressed exchange that converts subordinated debt into a lower-face-value amount of secured loans, but, in the process, dilutes first-lien collateral coverage. Those are just two obvious ways in which free-and-clear tranches could work to the detriment of secured lenders, managers say. Because free-and-clear technology is a recent innovation, however, there may be other pitfalls as yet unseen.

More issuer-friendly documentation in the form of incremental tranches, incurrence tests, and equity cures may well be a direct response to the rising liquidity in the loan asset class, which allows managers to enter and exit positions more easily and therefore may obviate the need for the buttoned-up terms that were necessary when the lender was married to a loan until maturity or repayment. Of course, this is cold comfort to managers who studied credit at the old school and are concerned that today’s less-restrictive terms may result in less-favorable recovery outcomes down the road.

Risk assessment
Innings of a baseball game is useful shorthand to describe where the market stands relative to the overall cycle. Some managers, however, prefer to describe the current cycle as a three-game series, with the first game over and the second now underway. To wit:

  • Game One (recovery/QE): That part of the cycle, which produced outsized returns for loans and virtually every other risk asset, concluded in 2013 as the Fed began tapering bond purchases and 10-year Treasury yields climbed from a decades-long low of 1.43% in July 2012 to the recent level of 2.5-2.6%.
  • Game Two (rate/event risks): The large early-cycle gains of Game One are now in the rearview mirror, but there appears to be little risk of a default spike over the next 12-24 months. Instead, managers say the paramount risks of this part of the cycle are a sudden change in the interest-rate curve or a disruptive outside shock, either of which could send liquidity to the sidelines and cause loan prices to fall.
  • Game Three (default/loss spike): This game will be played eventually, as it always is. The timing, however, will likely be several years into the future based on most economic prognostication, which views the chance of a near-term recession as remote – unless, of course, the U.S. economy is rocked by a catastrophic outside shock.

Given this framework, managers say the market is likely to be in the middle game of the cycle for a while longer. For the time being, the biggest risks for investors will be:

  • Event risk, in the form of an outside shock that sends investors to the sidelines and causes outflows from loan mutual funds to accelerate, while the CLO window slams shut.
  • Rate risk, such as either (1) an unexpected decline in rates or (2) a steeper rate curve that, in either case, could drive money from short-duration products like loans to longer-duration products like bonds, thereby crimping loan demand.

– Steve Miller

Follow Steve on Twitter for an early look at LCD analysis, plus market commentary.

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July 2014 European Leveraged Loan Market Analysis – Video, Slides

This is S&P Capital IQ’s monthly loan market update. In this post, we concentrate on the trends at work in the European leveraged loan market during 2014 so far, including an increase in M&A financing and some signs of heating in the market. We’ll also touch on the question of whether some slowdown is to be expected.

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Out of the €45 billion of leveraged loan issuance so far this year, M&A-related deals contributed €25 billion, more than double what was raised in the first half of last year. This total was boosted by some jumbo corporate M&A deals, most recently  the cross-border financing for Jacobs Douwe Egberts. Among sponsor-backed buyouts, LCD tracked an increase in the number of asset sales by corporates and families, bringing some welcome debut borrowers to the loan market.

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Institutional investors continued to show strong appetite for leveraged loans during the second-quarter, and heavy repayments on existing loans spurred them on. In fact repayments reached a record quarterly high of €16.6 billion, based on the S&P European Leveraged Loan Index, as the chart shows.

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Adding to institutional demand, there was lively issuance of new-generation CLOs, particularly during June, including some new managers entering the 2.0 market, and sources say the pipeline for further CLO issuance in the second half of the year looks healthy.

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Through much of the year so far, there has been relatively little complaint from buyside firms about leverage multiples, and indeed first-lien leverage is pretty much flat on last year at around 3.7 times EBITDA. But second-lien tranches are appearing more frequently, and this helped drive total leverage a little higher, to 4.9x. Some arrangers argue leverage is unlikely to spiral up and up because this would result in deals coming to market with low single-B ratings, these often being hard to shift in syndication.

eur5covlite

Instead, the market is showing its aggression in other ways – particularly in the use of covenant-lite loans. €10 billion of cov-lite paper – a record – has been raised this year, meaning that roughly one in three euros sold to fund managers had no maintenance covenants. The ELLI Index now includes a 13% cov-lite portion, the highest in its history – although a long long way behind the U.S., where the trend started.

EUR6

However, from the point of view of yields, Europe looks less aggressive than it did earlier in the year as this chart suggests. Behind the scenes, yields on domestic European deals were flat from the first quarter to the second. But in line with the weaker technical picture in the U.S. market, cross-border yields widened in recent months, dragging the average out too.

Looking ahead, some kind of summer slowdown is likely, but arrangers say they are pitching on some aggressively structured deals and will be looking out for signs of pushback among investors if terms get too heated.

 

The video is available here.

The URL for the video:

PDF slides of the video on Slideshare is available here.

URL for the slides:

While you’re on YouTube please subscribe to LCD’s YouTube Channel. That way you won’t miss any LCD videos. You can also subscribe by clicking on the link to the right of any LCD News email.

– Ruth McGavin

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CLO roundup: Issuance continues with more to price in Europe, U.S.

Traditionally the third quarter tends to be the least active of the year for the CLO market. As yet, however, there is no sign that issuance is taking a break for the summer, with five new U.S. CLOs pricing and another four in the near-term pipeline. Europe is also not quite done, with several more managers said to be eyeing a print before the end of July. Global volume YTD stands at $76.13 billion, according to LCD.

Stateside, a comparison between this month’s issuance and last year neatly sums up the ongoing strength of this year’s new issue market. At $5.67 billion with two and a half weeks yet to go, July 2014 supply has put July 2013’s full month supply $3.37 billion in the shade.

At $66.64 billion from 124 deals, according to LCD, issuance to date is currently fourth in line to the title of largest annual tally ever behind 2006 ($97.01 billion), 2007 ($88.94 billion), and 2013 ($82.61 billion). By comparison, YTD issuance in 2013 was $43.69 for 89 deals.

LCD subscribers can click here to get full story, analysis, and the following charts:

  • Global CLO Volume
  • Deal Pipeline, US and Europe
  • European arbitrage CLO issuance and institutional loan volume


Sarah Husband

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Leveraged loan default forecast remains benign in near term, LCD survey says

Loan managers expect the default rate to rise modestly over the next 12 months while remaining well inside the long-term average of 3.2%, according to LCD’s latest buyside survey, conducted in early June.

On average, participants see the default by amount (excluding Energy Future Holdings) inching to 1.48% by year-end, from an initial estimate of 1.08% in June (those figures equate to 4.81% and 4.41%, respectively, including EFH). Looking out further, managers expect the rate to push to 1.76% by June 2015 (EFH will have dropped from the lagging 12-month rolls by then).

LCD subscribers, please click here for full story including analysis and charts for:

  • Debt-to-EBITDA ratio for the most highly leveraged loans (large LBOs)
  • Share of outstanding loans rated CCC+ or lower
  • Shadow default rate
  • Share of performing loans bid at 70 or lower (excluding EFH)
  • 2016 maturity wall
  • Average cash-flow coverage of outstanding loans
  • Quarterly EBITDA growth
  • Leveraged loan default rate and imputed default rate


– Steve Miller

Follow Steve on Twitter for an early look at LCD analysis, plus market commentary.

 

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May 2014: US leveraged loan market analysis; video, slides

Welcome to S&P Capital IQ’s Monthly loan market update.

First, we’ll review recent market trends. In preview, the loan market weakened in April as a result of outflows from loan mutual funds and rising supply. Separately, Energy Futures chapter 11 filing drove the loan default rate to a near four year high.

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Loan prices, on average, fell around a quarter point in April. With the market’s supply/demand balance tilting toward buyers, S&P/LSTA Index returns fell to an eight month low of 0.18% from 0.34% in March. Over the first four months of 2014, the Index was up 1.3%.

sld2
Market conditions eased in April, in part, because of swelling supply. During the month, a series of new M&A-driven loan executions helped expand the universe of S&P/LSTA Index loans by $14 billion, to a fresh record of $724 billion.

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On the other side of the ledger, capital formation did not keep pace. Though CLO issuance climbed to a post-credit crunch high of nearly $12 billion in April, retail investors withdrew an estimated $1.3 billion from loan funds during the month based on data from Lipper FMI. It was the first month of withdrawals in nearly two years.

sld4
With the technical equation upside down in April, new-issue clearing yields rose 50-75 bps across the board, with BB loans clearing in a 4% context and single B paper at 5.5%, give or take. Not coincidentally, repricing volume fell to a 15-month low of $6 billion in April and no new such transaction was launched in early May.
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On the default front, Energy Future Holdings finally succumbed to bankruptcy in April. As a result, the loan default rate jumped to a near four year high of 4.6% from 1.2% in March. Beyond Energy Future, which is really a relic of the 2007 boom, managers are constructive on the near-term outlook. On average, they expect the rate, excluding of that particular name, to end 2014 at 1.9%, according to LCD’s most recent buy-side survey from mid-March. That would put it more than point inside the historical average.

sld6
Looking ahead, most players expect the market to remain relatively in balance in the coming months. Supply appears to be on the upswing, what with the calendar of M&A-driven loans now at a recent high. Capital formation, meanwhile, in the form of institutional allocations and CLO issuance persists, though the retail engine is, for the moment at least, in neutral.

– Steve Miller


The video of this presentation is available here.

The URL:

Click here to download PDF slides of the video on Slideshare.

URL for the slides:

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CLO problem not solved by Fed’s 2-yr Volcker extension, says LSTA

The Federal Reserve Board announced yesterday that it will give banking entities two additional one-year extensions to conform their ownership interests in and sponsorship of certain CLOs covered by the Volcker rule. The conformance period currently runs through July 2015, and the extensions would give banks until July 21, 2017 to either work with CLO managers to amend non-compliant CLOs, or divest of such investments. The extension applies only to CLOs issued prior to Dec. 31, 2013.

For a copy of the Federal Reserve Board’s statement, click here:

Under the Volcker Rule, CLOs that own bonds and are issued under Rule 3c-7 are ‘covered funds,’ and banks cannot have an ownership interest in a covered fund. Under Volcker, ownership includes ‘the right to participate in the selection or removal of an investment manager’ of the covered fund, outside of an EOD.

The extension is helpful in that it would reduce the impact of Volcker for the vast majority of CLO 1.0s. RBS CLO strategist Ken Kroszner, in a research note issued in response to yesterday’s announcement, says “nearly all legacy CLOs will have amortized by July 2017, so this amendment will likely remove some regulatory risk related to holding these positions for banks. The current 1.0 universe totals $135 billion and we have forecasted a $50 billion run-off in 2014 alone.”

However, the extension does not address the impact of Volcker on CLO 2.0s that will remain outstanding after July 2017. U.S. CLO 2.0s issued during 2014 have generally been structured as Volcker compliant, but the extension would leave uncertainty around the CLO 2.0s issued before 2014 – many of which are likely to be outstanding in July 2017.

“We expect that a vast majority of 2013 vintage CLOs ($80 billion issued in 2013) and most 2012 vintage deals ($55 billion issued in 2012) will still be outstanding at that time given most of these deals were issued with 4-year reinvestment periods. The success of refinancing CLOs with ‘Volcker compliant language’ may help mitigate some of this risk down the road as nearly all of these deals will end their non-call periods before 2016 thereby leaving more than a 1.5 year buffer for most CLOs,” said Kroszner.

As such, although it provides holders of non-compliant CLO debt with additional time to either amend or dispose of this paper, the proposal would fall short of the solution proposed by the Barr Bill, which was approved by the House Financial Services Committee (FSC) last month. That legislation would provide for the grandfathering of all CLO debt issued before Jan. 31, 2014, where the only indication of ownership interest is the ability to participate in ‘for cause’ manager removal.

In response to yesterday’s announcement, the Loan Syndications and Trading Association (LSTA) says the extension will not solve the problem, and that issuing a comprehensive rule that would completely grandfather CLO notes issued prior to the publication of the final rule is needed in order to divert impairment of the CLO market.

“While the LSTA appreciates the Federal Reserve’s efforts to mitigate the damage that the final rule implementing the Volcker Rule would cause to banks holdings of CLO AAA and AA rated notes, a two-year extension of the conformance period does not solve the problem,” said Elliot Ganz, general counsel and executive vice president for the LSTA.

“In its recent cost-benefit analysis, the OCC estimated that the forced divestiture of CLO notes by banks required under the Volcker Rule could cost U.S. banks up to $3.6 billion,” said Meredith Coffey, executive vice president of research & analysis for the LSTA. “In contrast, the expected credit losses on banks’ holdings of CLO notes are less than $2 million. It is ironic that the Volcker Rule, which is designed to limit banks’ investments in risky assets, would force banks to realize billions of dollars of losses in a very safe investment, due to a fire sale.”

Meanwhile, Congressman Scott Garrett, Chairman of the Financial Services Subcommittee on Capital Markets and Government-Sponsored Enterprises, issued a statement yesterday instructing the U.S. financial regulators to go back to the drawing board on their impending “fix,” or risk having it done for them.

“Since the banking regulatory community is unwilling to correct their mistakes, Congress must do it for them. To be frank, this might also have to include Congress looking to make changes to the law such as subjecting these agencies to the appropriations process and further consolidation,” he said. – Sarah Husband

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Volcker Rule’s Non-Exemption Of CLOs With Bonds Holds Potential To Disrupt Market

The reaction to the final version of the Volcker Rule has generally been positive, especially given the obvious attempt by the federal agencies involved to exempt the CLO market from the new regulations. However, there is still concern about possible disruptions to the market in the event that CLO managers are forced to offload securities from their collateral pool, or if banks engage in forced selling of non-exempt transactions.

Elliot Ganz of the LSTA summed up the state of affairs nicely: “While this was a major win, not everything is rosy.”

First, the good news…
Prior to the final rules, there was much concern that CLOs might be categorized as covered funds (hedge funds or private equity funds), as the Volcker Rule prohibits U.S. banks from ‘owning’ covered funds. Banks would have not only been no longer able to invest in CLOs, but also may not have been able to make markets or warehouse CLOs. However, the final rules have gone a long way to exempt loan securitizations (CLOs) under certain conditions – specifically if they do not include bonds or securities.

…And then the not-so-good news
This specific requirement that exempt CLOs must not own securities creates a large issue, however, given the majority of 1.0 and 2.0 CLOs have bond baskets. Furthermore, because there is no “grandfathering” provision in the final rules, any CLOs still owning bonds on July 15, 2015 will not be exempt from the new regulations. As a result, for non-exempt funds CLOs, U.S. banks could not hold an ‘ownership’ interest after July 2015.

A lot remains unclear at this point, including to what extent the Volcker Rule might affect the European CLO market when it comes to U.S. banks investing, warehousing, or trading in European CLOs. Initial reactions from market players here suggest that while Volcker will affect European CLO managers, the impact is likely to be much less severe than for the U.S. market. Nonetheless, any thinning out of the potential triple-A investor base should U.S. banks be unable to invest in the senior debt of non-exempt CLOs is not good news for the development of the market, sources say.

Questions also remain around what constitutes ‘ownership’ of a covered fund, and whether a bank owning debt tranches of a non-exempt CLO equates to ‘ownership’ of a covered fund. The Volcker Rule defines ownership as “any equity, partnership, or other similar interest.” says Wells Fargo CLO analyst David Preston in his Dec. 16 report, CLO Salmagundi: A Deeper Look at the Volcker Rule. Under this definition, owning debt tranches of a non-exempt CLO is not considered ‘ownership’.

However, the “other similar interests” aspect to the definition includes the “right to participate in the removal of… an investment advisor… of the covered fund, (excluding the rights of a creditor to exercise remedies upon the occurence of an event of default or an acceleration event)”, and most CLOs allow triple-A investors certain rights regarding manager replacement, continues Preston.

There is much debate around this particular ownership issue, and in most cases triple-A investors’ ability to remove a manager would fall under the “the rights of a creditor to exercise remedies upon the occurence of an event of default” exclusion, and so would not constitute ownership. However, there is a question about whether the removal rights associated with the ‘for cause’ events often included in the Collateral Manager Agreement fall inside or outside of a perceived event of default, says Preston.

Further debate concerns the key man event and whether or not this could be used as an example of ownership under Volcker.

On a different note, it would appear initial concerns that U.S. banks may be restricted from trading non-exempt CLOs may prove unfounded, as Volcker contains a market-making exemption for banks to act as market makers of covered funds – subject to certain limitations that may impact market liquidity, Preston says.

The consequences
The result could be widespread market disruption, says the LSTA’s Ganz.  Under a scenario where banks could not own CLO tranches, either CLO managers would look to exclude these bonds from portfolios ahead of July 2015, or banks will have to sell out of non-exempt CLOs, putting price pressure on triple-A tranches and leading to potential losses for those banks.

A final course of action, Preston suggests, is to amend CLO documents to list all manager removal clauses specifically as events of default to remove any ambiguity, and to ensure that a close technical reading would not imply that controlling class investors are “owners.”

With regard to the first point, the issue may not ultimately be too big: managers effectively would have until mid-2015 to sell bonds, and 2.0 CLOs generally have smaller bond holdings than 1.0s. In addition, many in the 1.0 group are likely to have amortized or been called by the deadline, according to Preston.

However, while banks, as investors in CLO tranches, will likely push hard for CLO managers to offload their securities and to amend deals to prohibit them from owning securities going forward, some managers simply may not want to sell, or may not be able to sell or amend deals due to resistance from their equity investors.

This could all lead to a differentiation in both value and liquidity between compliant and non-compliant CLOs, as well as the likely emergence of a new CLO 3.0 structure that includes no allowance for bond buckets.

As a result, the LSTA may return to the regulatory agencies to seek relief with respect to the ownership interest. According to Ganz, this would concern “…in particular whether CLOs that have ‘for cause’ manager replacement triggers in triple-A notes are considered ownership interests.” There is also the possibility of asking the agencies to defer the effective date for the divestment of ownership interests.

It may also be possible for triple-A noteholders to contractually give up their replacement rights, thereby negating the indicator of ownership and making it permissible to hold the security, although this option is far from clear, Ganz says.

Ultimately, if there is no regulatory relief forthcoming and existing CLOs do not sell their securities by July 2015, banks would no longer be eligible to hold those triple-A securities.

Further clarity on the rules and their impact should emerge in the coming weeks. Some issues will be thrashed out – if not fully resolved – on the LSTA’s Volcker Rule Webcast, which is being held at 3:00 p.m. EST on Wednesday, Dec. 18. – Sarah Husband

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YouTube, slides: Dec. 2013 European leveraged loan market analysis

LCD’s video analysis detailing the European leveraged finance market during November is now on YouTube.

Loan issuance was €5.4 billion during the month while high yield issuance was €7.4B. Both markets remain buoyant and open. Secondary markets were up, while inflows into high yield funds are estimated to be €1B. The European loan index (ELLI) was up. Four CLOs priced in November, with seven still in the pipeline.

This month LCD looks at:

  • Leveraged loan prices
  • High yield bond prices
  • ELLI multi-currency loan returns
  • Volume: new issue loans vs HY bonds
  • ELLI default rate

The video is available here.

The URL for the video:

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Opal CLO summit: AAAs are key theme amid cautious optimism for 2014

This week’s Opal CLO Summit in Southern California reflected what has been a positive year for the CLO market, although optimism for the year ahead was measured.

More than $76 billion of new CLOs have been issued this year, and next year is expected to get off to a strong start with the pipeline looking full. Managers will look to take advantage of the anticipated renewed demand for the asset class that comes with a new financial year, and both established and new managers will likely look to complete as many deals as possible ahead of the implementation of risk-retention regulation.

There was some discussion of the regulation during the two-day event, but the focus was mostly on arbitrage. Indeed, one of the opening panels of the conference – tackling the triple-A conundrum – established that the recurrent theme of the event would be the outlook for triple-A spreads.

Research analysts speaking at the event had already outlined their predictions for triple-A spreads in their various market outlooks published over the past couple of weeks. All of the panel participants expect triple-A spreads to contract to roughly L+125-135 over the next year, though they believe the tightening will lag other products.

The relative-value play will help bring liability spreads in, as spread-tightening across other ABS products boosts demand for CLO triple-As. Another contributing factor could be the large amount of CLO 1.0 amortization expected next year – in the area of $40-50 billion, some panelists say – which could also increase demand for the triple-As on primary CLO 2.0s as investors look to roll previous commitments into new paper.

However, there are many pieces to the triple-A puzzle and the panel participants took their time exploring various factors.

Demand, for one, is central to the triple-A issue, and with a third of the previous triple-A investor base gone for good as a result of the crisis, the supply/demand equation has gone askew amid this year’s robust CLO volume.

The impact of the FDIC charge also helped curtail regional banks’ appetite during the first quarter, while the Volcker Rule had threatened to remove bank investment in CLOs altogether (although an initial read of the final draft appears to indicate that as long as CLOs do not own bonds, Volcker does not apply).

Given the supply, larger triple-A investors have been able to determine pricing, so that once spreads across the asset class widened this summer, CLO triple-A spreads have remained wide.

There is some tiering evident across managers, and some established managers may have a following of triple-A investors they can take from deal to deal. However, while the reputation and experience of a manager remains important to triple-A investors, there were gripes about the subsequent demand from these investors that managers accept reduced fees.

“If you squeeze managers to the point where they can’t provide proper teams/infrastructure/compliance required to make good investment decisions, then you will be left with the two guys and a Bloomberg model,” said a panelist.

Given the current supply/demand dynamic, some doubt how quickly triple-A spreads will narrow, in spite of the research analysts’ predictions for compression next year.

Even if new investors are slowly showing an interest in the asset class – panelists see increased numbers of triple-A investors versus last year – the time and effort it takes to get those investors approved was described as “gargantuan.”

One panelist suggested that without new investors in the asset class, there may not be meaningful spread compression until risk-retention regulation forces consolidation across the manager space, reducing supply.

Ironically, primary CLO supply could come to a halt anyway, assuming loan asset spreads continue their descent in the absence of any meaningful corresponding compression on the liability side, so that the arbitrage will simply not work.

Better education
One discussion to emerge concerned what is required to bring new investors to the asset class. Certainty around regulation should help when various final rules become effective. But certain panelists said better education about the market and CLO structures is needed to encourage investors who may understand the value in triple-As at current spreads, but who are perhaps nervous about actually investing in the space.

CLOs tend to be viewed as a highly complex investment, and some institutional investors have been reluctant to invest in the structure due to what they believe to be an onerous resource burden required to make an informed investment, according to several panelists. “It’s not a homogenous asset class, and the level of due diligence required is too onerous,” suggested a panelist.

Meanwhile, the perception of CLO space as a tainted asset class in the aftermath of the credit crunch also acts a deterrent. In particular, panelists said this was a factor preventing the participation of potential investors such as corporate treasurers with huge cash amounts. “Are CLOs attractive to the cash/short duration investor?” asked one panelist. “Yes, from a credit-risk perspective, but the legacy of the crisis is so severe that the perceived toxicity of the product is still a huge hurdle.”

The argument went so far as to say that while 145 bps looks attractive from a relative-value perspective, it perhaps isn’t so appealing to a corporate treasurer who is unwilling to risk career suicide on a CLO investment.

The takeaway was that better investor education could help improve the general understanding and perception of CLOs, and in time could help deepen the investor base. As part of that education process, panelists suggested that software and data tools to help evaluate and understand structures would be helpful, while noting that standardization of CLO documentation might also prove beneficial.

To this point others argued that over-standardization that removed flexibility for a particular CLO manager could also act as a disincentive to established managers going forward. “As soon as you standardize, you don’t get any benefits as a manager above first-time issuers,” said one CLO manager. – Sarah Husband

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YouTube, slides: December 2013 US Leveraged Loan Market Analysis

LCD’s video analysis detailing the US leveraged finance market during November is now on YouTube.

New-issue leveraged loan activity pushed further into record territory during the month. The S&P/LSTA Index posted a 0.49%. The universe of S&P/LSTA Index loans grew by $22 billion, to a record $674 billion. Inflows accelerated. The loan default rate eased.

Looking ahead, the calendar of new M&A-driven transactions remains light.

This month LCD looks at:

  • Leveraged loan volume; M&A loan volume
  • Average Bid of S&P/LSTA Loan Index
  • S&P/LSTA Index Loans Outstanding
  • Visible Inflows
  • Average New-Issue Clearing Yield of First Lien Loans
  • Loan Default Rate
  • M&A Institutional Loan Forward Calendar


The video is available here.

 

PDF slides of the video on Slideshare.

 

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