Impressive as CLO volumes have been of late, there are signs the market is being overwhelmed by supply. Participants warn that the CLO investor base is not yet deep enough to cope with the expected pricing of up to $100 billion of new CLOs this year. The booming CLO market is already causing loan spreads to narrow once again, threatening arbitrage and potentially undermining issuance.
Progress has been made on expanding the CLO investor base this year however. Volcker may have sidelined bank investors, but the subsequent availability of financing saw hedge funds move into the AAA space, followed by insurance companies that get favorable NAIC treatment.
What’s more, banks are starting to return. Having fallen to 42% of the indicative new issue CLO investor base for AAAs in the first quarter of 2014 from 71% in the second half of 2013, banks accounted for 56% of the AAA investor base in the second quarter of 2014, according to J.P. Morgan.
Managers are also getting creative to attract investors in others ways. CIFC included a repack/quanto swap in its recent $723 million transactionto allow yen-denominated AAAs to be sold into parts of Asia.
Meanwhile, institutional investors continue to raise new CLO investment funds, including Santaky Advisors, Fair Oaks Capital and Eagle Point Credit, sources say.
These are positive developments for sure, but in spite of them, Wells Fargo warned in its outlook for the second half of 2014 that the volume of primary issuance will make it difficult for spreads to move significantly tighter.
On average, AAA liabilities cleared at a discount margin of 145 bps in June and 150 bps for the second quarter as a whole, down from 156 bps in the first quarter, according to Wells Fargo.
Looking ahead, Morgan Stanley anticipates AAA spreads tightening to 135 bps by year-end. J.P. Morgan has a range of 135 bps-140 bps.
Pick and choose
The wealth of supply means investors can be highly selective and dictate terms for all but the most established issuers. Sources say the gap between where Tier 1 managers are printing deals and where Tier 2 and 3 managers are is as wide as it’s ever been, at roughly 20 bps now, compared to 10-15 bps in 2012.
Meanwhile, further down the capital stack, the large supply has thinned out the pool of investors for BBB/BB-rated mezzanine notes, typically hedge funds and structured credit funds. Managers and arrangers have commented that it has been much harder to fill these tranches recently, especially for less regarded managers, with mezzanine spreads softening.
Spreads across mezzanine tranches have widened as a result, perhaps as much as 15-25 bps over the past month, sources say. New issue BBB spreads are currently ranging from 415-440 bps, while BB spreads are at 615-660 bps, J.P. Morgan said in its 2014 Midyear CLO Outlook research report (note that JPM’s new issue spreads represent a range of spreads to indicate manager tiering).
Narrowing loan spreads
On the other side of the arbitrage equation, loan spreads are again narrowing. CLOs have become their own worst enemy here, filling the gap left by retail investors, and reversing the widening trend, which started with the first retail outflows in April.
The result: having widened all the way back to L+438 at the end of May, U.S. loan spreads have since retraced their steps back down to L+392, according to LCD.
For some managers, the arbitrage has been pushed to the point that they are once again rethinking whether to press ahead with plans to print their next transaction.
“The arbitrage is getting harder and harder, everyone is discounting fees and deals just don’t stand on their own,” said a manager. “Maybe you get to a 10% return on an optimistic case.”
Whether these dynamics will end up slowing the pace of new CLO supply stateside remains to be seen. Managers are motivated to issue transactions; both to replace the flow of legacy deals running off – Wells Fargo has tracked $23 billion in CLO 1.0 run-off so far this year – and to lock up AUM ahead of risk retention.
According to Deutsche Bank in its European Asset Backed Barometer research report last week, “Although US supply is at a post-crisis record, any sustained continuation of the same in the face of tightening loan spreads will be predicated upon senior CLO spreads in the primary tightening further.”
No market operates in a vacuum, and the current dynamics stateside are impacting the European CLO market, even if the arbitrage remains more favourable in Europe, helped by tighter liability spreads. European CLO equity currently offers roughly 13%, sources say.
European liability spreads remain inside those in the U.S., and there is some evidence of tightening here too, with two transactions last week securing a 3ME+135 print on the AAAs.
Further benefit could come from a general tightening of European ABS spreads on the back of the European Central Bank’s efforts to revive the securitisation market, including ABS purchases, even if the CLOs themselves are not included in the purchases. And similar to the U.S., the arrival of new investors will also help bring spreads in. Of note has been the recent entry of large European banks investing in size in the AAAs, according to sources.
However, the extent of European spread tightening still remains subject to U.S. market dynamics, given the historical trend for European liabilities to print outside of U.S. liabilities.
According to Deutsche Bank, “Senior European CLO 2.0 spreads at 140 bps also offer significant value, especially compared to peripheral RMBS. However here, we see spread tightening being held back by US product – while AAAs in the US primary have tightened recently to 140 bps, it is still on top of European spreads.”
Similarly, the relative value between the two markets means that while spreads on European mezzanine bonds have been tighter than in the U.S., they too have widened in recent weeks. “Mezzanine is much tighter in Europe, making this paper attractive only to European investors. However, these same investors look at the widening U.S. mezzanine spreads and seek wider European spreads as a result,” says one source. – Sarah Husband