US CLOs revive as loan markets surge

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By:
Joti Mangat
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The collateralized loan obligation market has been one of the surprise recovery stories of the past year. US managers are reappraising the opportunities it provides. Will the revival continue, and can it catch on in Europe? Joti Mangat reports.

STABILIZING DEFAULT RATES, tightening credit spreads and improving investor confidence have all underpinned the rally in the loan markets this year. They have also spurred a remarkable renaissance in the US CLO market.

The market’s largest CLO manager, Babson Capital Management, says the structure has proved its mettle. "To varying degrees global investors are going to look back through the historical lens and ask how did this asset class perform versus similar types of risk. These structures did just about everything they were expected to. With the passage of time people can go back and see the benefits, and this is driving increased appetite for CLOs," says Russ Morrison, managing director and head of high-yield investing at the firm.

The sector’s performance
over the past year has been stellar and might yet still have room to run

The sector’s performance over the past year has been stellar and might yet still have room to run. Although de-risking by global investors in the wake of the Japan disaster has unwound some of this year’s rally (especially at the double-B and triple-B level), triple-A paper maintained its gains and most market observers maintain their medium-term buy call on the market.

Some argue that the rally in January and February was too fast and too furious but that the market has subsequently stabilized. "The value is there again and in our view investors should consider current levels as a good entry point," advised Citi’s global structured credit team in March. Equity investors, meanwhile, which hold the riskiest part of the capital structure, say they have seen returns in the past year as high as 50%.

"Most of the rally has probably already taken place at the equity tranche level and we will continue to see price movement to the upside with this effect most pronounced up the debt stack," concurs Jeff Herlyn, principal of Tetragon Financial Management, a New York based ABS fund manager that focuses on CLO equity investing.

High-yield boom boosts managers

While the lack of transparency inherent in many asset-backed CDOs led to crippling uncertainty regarding their value during the crisis, credit losses on CLO loan portfolios forced managers to de-lever deals to pass transaction stress tests. Furthermore, the ability of CLO managers to reinvest during the life of the deal allowed them to take advantage of the recovery in high-yield credit demand.

"Market expectations for the next 12 to 24 months are positive for the US credit market, and CLOs in particular"

Josh Terry, Highland Capital Management
Josh Terry, managing director with Texas-based asset manager Highland Capital Management
"A large percentage of the increase in high-yield bond volume went to pay down loans, allowing CLO managers to reinvest proceeds into loans trading below par and thus improving their over-collateralization (OC) tests," says Josh Terry, managing director with Texas-based asset manager Highland Capital Management.

The number of US CLOs failing a minimum OC test peaked at 57.1% in June 2009. That number had fallen to less than 10% by the end of last year, according to Fitch Ratings. Indeed, the proportion of US CLOs containing defaulted debt fell from a high of 6% in 2009 to around 2% by the end of 2010. Managers preparing new deals are now looking at ways of improving the resiliency of the structure by increasing subordination or using stricter credit criteria for selecting loans. For example, post-crisis CLO structures now include a larger first-loss cushion, of between 11% and 25% of total liabilities, compared with 7% to 8% for pre-crisis deals.

Europe’s recovery lags the US

Recovery in Europe has been less dramatic. Although loan and CLO spreads prices have tightened, they are still wider than US levels. "The European loan market has still not achieved the same level of prepayments and refinancing that we have seen in the US and there has been a general lack of de-leveraging," says Miguel Ramos-Fuentenebro, managing director at GSO Capital Partners and founder of the Carador Income Fund, a London-listed closed-end fund focused on US CLOs.

He cites traditional European grievances such as restructuring laws and recovery rates as well as the sovereign debt crisis as possible reasons for the lack of activity. "We’ve never had a large exposure to euro loans, but [during March] we further reduced our position," he says. Europe generated a single CLO last year, and the €6.1 billion of new loans priced so far in 2011 pales beside the market recovery in the US.

Already this year, US sponsors have launched nearly $2 billion of CLOs, compared with $4 billion for the whole of 2010, according to Standard & Poor’s Leveraged Commentary and Data (LCD). The rapid recovery in the US loan market means that supply is fast approaching pre-crisis levels.

Buoyed up by the prospect of rising interest rates, investor demand for floating Libor-based returns drove $131.3 billion of loan supply in the first quarter of 2011, an increase of more than 50% on the same period in 2010 and the highest level for the period since 2008.

Furthermore, the data show that CLO managers are increasing their activity in the primary loan market, accounting for more than 50% of institutional demand in Q4 2010, according to S&P LCD. Dealers now expect 2011 CLO issuance to reach between $10 billion and $15 billion.

Yield levels start to bite

However, as improving credit fundamentals and growing investor demand reprice the loan market, participants are asking how long new loans will be able to generate the yields capable of making the CLO logic work. "With senior secured loan portfolios offering spreads in the Libor plus 300 basis points to 350bp range the arbitrage is currently working, but it is really tight," warned Carador’s Ramos-Fuentenebro in March.

Whether or not the arbitrage remains in play will depend on how far loan spreads come in, and whether CLO liability spreads are also able to narrow. Managers are confident, at least as far as triple-A CLO spreads are concerned, that investor demand will be sufficient to keep the window open. Tetragon’s Herlyn says that CLOs – particularly triple-A CLO liabilities – are too cheap. "We may continue to see a tightening on the liability spread side. Compared to other triple-A ABS or corporate credits, CLO triple-As at Libor plus 150bp (that have typically not lost a material amount of money) may be simply too cheap. Where loans have backed up on credit market sentiment, you may not see a commensurate back up in CLO spreads. You may see convergence as more investors move to exploit this basis," he explains.

Loan market rally accelerates
Global leveraged loans, 2010/2011 monthly breakdown
Source: Dealogic

With credit fundamentals returning to long-term averages, and interest in CLOs building again, managers and underwriters are racing to reassemble the global patchwork of banks, insurance companies and funds that funded some $80 billion of supply in 2007.

Carador’s Ramos-Fuentenebro says that although the early feedback from investor outreach has been positive, he expects the process of reinvigorating the investor base to be measured. "Our experience over the past 18 months has been positive but gradual. Banks and insurance companies need time to take a decision to re-enter a market where there is clearly a perception issue. The impact this has on spreads will depend on how many institutions have demand for paper. Triple-A spreads have already tightened from 170bp to 150bp, and could come in to 130bp by the end of this year," he explains.

The greater hope is that as triple-A spreads come in, so too will spreads on the rest of the capital structure. A potentially interesting source of demand, given their funding advantage, and one that fell out of the investor base in 2008, is Japanese banks. Managers claim that several Japanese institutions have recently re-entered the triple-A market, attracted by the relative cheapness of CLOs compared with other triple-A ABS classes such as UK RMBS and US credit cards.

Environment may support CLO market

With the US economy entering a period of slow growth, Highland’s Terry argues that the combination of the low-default environment (with consensus levels ranging between 1% and 3%) and the improving fundamental economic outlook is potentially supportive of the CLO market. "Market expectations for the next 12 to 24 months are positive for the US credit market, and CLOs in particular. Modest growth expectations should keep borrowers from being too aggressive with respect to leverage and debt quantums, while at the same time keeping their cash flow – and thus cash flow into CLO structures – consistent," he reckons.

But the market will not return to its pre-2007 levels. Carador’s Ramos-Fuentenebro concedes: "Before the crisis, banks were doing one transaction a week in the CLO market. This was heavily predicated on demand for triple-A paper coming from structured investment vehicles and other leveraged buyers. Now that these have all been taken on balance sheet or unwound, triple-A CLOs are not driven by leverage and capital requirements. That advantage is long gone."