NEW YORK, Nov 27 (LPC) - Issuance in the US Collateralized Loan Obligation (CLO) market is forecast to fall next year as spreads remain wide, eating into returns paid to the most junior investors in the funds.
Banks are calling for US$75bn to US$100bn of US CLO volume in 2020 after more than US$108bn was arranged this year through November 22. A record US$127.7bn of the funds was issued in 2018, according to LPC Collateral data.
The US$656bn US CLO market, the largest buyer of leveraged loans, has been battling criticism from regulators and lawmakers, and dealing with three rate cuts that curtailed the pitch of the funds as a safe-haven in a rising-rate environment. The Federal Reserve hiked rates nine times between December 2015 and December 2018, but since June has made three cuts.
“It has certainly been a year of challenges and surprises for the loan and CLO markets, but a key theme that has revealed itself in the second half of the year was a return to credit fundamentals,” said Dagmara Michalczuk, portfolio manager at Tetragon Credit Partners.
Morgan Stanley is calling for US$75bn of broadly syndicated US CLO volume in 2020, while Barclays has forecast US$80bn-US$90bn of similar funds, according to research reports. Bank of America and Nomura are both forecasting US$80bn-US$90bn of issuance, Wells Fargo and Deutsche Bank are both expecting US$90bn and JP Morgan is calling for US$90bn-US$100bn.
The higher-end of the forecasts would place 2020 as the fifth or sixth largest year of issuance on record.
“The market has proven to be resilient,” said Rachel Russell, co-head of the US CLO new-issue business at Morgan Stanley. There is a “global buyer base…and every year we’ve continued to see new investors. If one region has some disruption, we’ve seen a pick up (in buyers) in other regions.”
Japanese bank participation in US CLO Triple A tranches has been lower than last year following risk-retention regulations released by the Bank of Japan. But US investors – including existing and new buyers – have stepped in, leading to a number of broadly syndicated senior tranches, she said.
US family offices and foundations, as well as larger traditional mutual fund managers, have also been interested, said Christopher Long, founder of Palmer Square Capital Management.
“The CLO spaces has gotten more widespread adoption in terms of the types of clients as well as the depth of how they are invested; that’s a good thing and it’s due to the track record of low defaults and the fact there has been a premium yield in CLOs,” he said.
Mutual funds overseen by Eaton Vance and Western Asset Management both announced this year that they could increase their exposure to CLOs.
Spreads on CLO tranches are expected to remain wide after gapping out in 2019 with Triple As widening to an average of 134bp last month from an average 118.75bp in October 2018, according to LPC Collateral.
Morgan Stanley forecasts Triple A spreads to remain at 134bp, while Nomura said spreads may tighten modestly. Morgan Stanley expects Double B tranche spreads to increase to 900bp from 825bp currently. In October 2018, BB spreads were around 600bp.
Higher spreads can eat into distributions to investors in the most junior portion of a CLO, the equity, who are paid with the interest remaining after the fund’s debtholders are paid.
A 32% drop in the three-month London Interbank Offered Rate (Libor) this year through November 26 has put additional pressure on the asset class because CLOs pay debt investors a coupon plus Libor, so as Libor falls so do investor payments.
The drop comes ahead of the 2021 deadline for Libor to be phased out. Its recommended replacement, the Secured Overnight Financing Rate (SOFR), a broad measure of the cost of borrowing cash overnight collateralized by US Treasury securities, has not been widely adopted by the loan or CLO markets.
The market will also need to deal with an anticipated uptick in defaults – Fitch Ratings expects the default rate to rise to 3% by the end of 2020 from 1.8% in November – and the potential for an increase in downgrades, which could weigh on the funds.
To prepare, investors pushed CLO managers to allow for the ability to swap out defaulted or deeply distressed assets with similar loans that offer better recoveries in the next downturn. Some funds also included larger buckets for Triple C rated credits beyond the typical 7.5%.
“The credit quality and performance of CLOs in the US will weaken in 2020 as corporate leverage continues to creep up and CLO structural protections loosen,” Moody’s Investors Service analysts wrote in a November 26 report. “Issuance will decline from its historically high levels over the past few years, owing to investor concerns over late-cycle credit risks and high funding costs.” (Reporting by Kristen Haunss; Editing By Jon Methven)