The collateralized loan obligation (CLO) market is on a tear. A confluence of factors — chief among them increased demand from a broader range of investors and impending regulation that could leave some CLO managers out of the game in the future — has set the stage for what could be a record year.
More than $50 billion of U.S. CLOs has been raised so far this year, compared with $82 billion for all of 2013, and analysts at the Royal Bank of Scotland (RBS) expect volume to top $55 billion by the end of the first half of 2014.
Revised bank forecasts range as high as $100 billion for the year — JPMorgan Chase & Co.’s prediction as of early May — which would top even the $97 billion market peak of 2006. And whereas not everyone is that bullish, it is now widely expected that 2014 will be the market’s biggest year since the financial crisis. “This pace might not be sustainable for the rest of 2014, but I do believe we’ll eclipse last year’s $82 billion,” says Ken Kroszner, head of CLO strategy at RBS in Stamford, Connecticut.
As with anything related to an investment vehicle that begins with the word “collateralized,” the reasons for this surge in volume are complicated. The market started the year off in a slump following the December 2013 publication of the final draft of the Volcker Rule, which contains regulations that prohibit, among other things, U.S. banks from investing in the debt of CLOs that own bonds. U.S. banks had been the largest buyer of CLO triple-A paper, the tranche that makes up 70 percent or so of the typical CLO.
CLOs pool high-yield corporate loans and slice them into securities of varying risk and return, with ratings typically ranging from triple-A down to double-B. The lowest-rated, highest-yielding tranche is known as the equity.
There was little clarity on the Volcker Rule in the first few months of this year as lobbyists for CLO players continued to push for an out — a grandfather clause, for example — that would allow existing CLOs to keep their bond buckets. Still, slowly but surely CLO underwriters and managers began to forge ahead with new Volcker-compliant, or bond-free, transactions.
And, as the months went on, they found healthy demand for triple-A paper from the broader CLO buyer base comprised of U.S. asset management companies, insurance companies and Asian (primarily Japanese) banks. This demand may be in part because of more attractive triple-A spreads. The average interest rate paid on triple-A paper was about 150 basis points over LIBOR in May, according to Wells Fargo & Co. That’s up from a spread as low as 110 basis points on triple-A tranches last year.
“I think with the wider [triple-A] spreads and the continued dearth of product out there for traditional fixed-income investors, this market became something that you couldn’t ignore,” says John Popp, head of the leveraged investments group at Credit Suisse Asset Management (CSAM) in New York. “Of course, there’s been a desire to broaden the investor base for quite some time. But I also think [the Volcker Rule] may have forced underwriters and managers to engage in a broader dialogue, away from the usual suspects at the big money-center banks.”
Increased demand from other types of investors has effectively offset diminished interest from U.S. banks, which, though they can invest in the new “Volckerized” deals, have their plates full dealing with the non-Volcker-compliant CLO debt they already own. This stood at roughly $70 billion worth when the Volcker Rule was finalized in December, according to Loan Syndications and Trading Association, a New York–based industry association. Regulators have given banks an additional two years to abide by Volcker, pushing the conformance deadline to July 21, 2017.
CLO managers, meanwhile, are taking advantage of interest from other investors and trying to get deals done ahead of additional regulation that looms: risk-retention rules proposed by the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act, which may require CLO managers to hold 5 percent of the debt they package or sell. “I think there are a lot of CLO managers that are not going to be able to come up with the capital to fulfill the risk-retention requirements,” CSAM’s Popp says. “In the meantime, that will incentivize many managers and underwriters to print while they can.”
Another factor making it attractive to issue CLOs now is the fact that retail loan funds have been seeing consistent outflows. There have been net outflows from loan funds for seven of the past eight weeks, totaling $3.3 billion, according to Lipper. “The retail outflows have really helped our market because it’s brought prices down a bit, and it’s stopped the repricings that we’d been going through earlier this year, which was constraining portfolio spreads,” says Lauren Basmadjian, a portfolio manager with Octagon Credit Investors who manages both CLOs and separate accounts. “The CLOs are more discriminating buyers because they have liabilities on the other side.”
Meanwhile, issuance marches on, with more than $6 billion of CLOs issued so far in June, according to Standard & Poor’s Leveraged Commentary & Data. That includes a $1.54 billion deal for Apollo Global Management raised by underwriter JPMorgan, the largest CLO to price since the credit crisis.
Days after JPMorgan raised its 2014 forecast for CLO issuance in May, Morgan Stanley boosted its forecast to as much as $85 billion. Wells Fargo had already bumped its prediction up to as high as $90 billion in April.
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