August 28, 2019 / 7:43 PM / 3 months ago

Wide spreads and a hunt for higher-rated credits strain CLO equity

NEW YORK, Aug 28 (LPC) - US Collateralized Loan Obligation (CLO) spreads widened for the third straight month amid falling interest rates, global market volatility and a year of strong issuance, which is weighing on returns to the funds’ most junior investors.

Spreads on the most senior and largest portion of broadly syndicated CLOs ranged from 130bp to 145bp in August after hitting an average of 134bp in July, according to Refinitiv LPC Collateral data. JP Morgan forecasts a midpoint Triple A spread of 145bp at the end of the year.

Falling Libor levels as the Federal Reserve (Fed) in July cut rates for the first time in more than 10 years, the US-China trade war and the resulting volatility have all put negative pressure on the funds, which are the largest investors in the US$1.2trn leveraged loan market. Triple A spreads have also remained wide on strong volume, which is just off last year’s record pace as managers try to tap investors already heavy on CLO allocations.

If CLO issuance were to slow, it could mean less capital available for companies or may push borrowers to alternative lenders that may charge a higher premium to lend.

There has been more than US$80bn of US CLOs arranged this year through August 27, down from US$87.2bn during the same period in 2018, a record year of issuance with full-year volume of US$128.1bn, according to Refinitiv LPC Collateral data.

“Heavy primary market supply coupled with modest investor demand, has kept spreads a little soft in the Triple A area,” Jason Merrill, investment specialist at Penn Mutual Asset Management, said in a telephone interview.

Investors turned to floating-rate products like loans the last few years as the Fed hiked rates, because their payments increase when rates rise. But that benefit is lost when rates fall. Libor, the rate companies use to set interest payments, has also been falling, with the three-month rate dropping 25% since the start of the year to 211.7bp August 27.

CLOs pay their investors a set rate plus three-month Libor from interest payments received from companies that borrow in the leveraged loan market, on the often cheaper one-month contract. Taken together, the amount leftover to pay equity investors, who receive the interest remaining after the fund’s bondholders are paid, is reduced.

“If you think Libor is headed down materially, like another 75bp, you are going to have a lot of loan investors say, ’Maybe I’m not going to do as much floating-rate products,’” Merrill said. “Libor falling is going to lead to less demand for loans, which will hurt loan prices, so all of this is contributing to this environment of weakness in spreads.”

Libor is dropping as markets prepare for its demise after Andrew Bailey, chief executive officer of the UK’s Financial Conduct Authority, said it should be phased out by the end of 2021 because there were insufficient transactions underpinning the rate following accusations bankers manipulated the benchmark.

“Taking a look at absolute yield, levels have dropped, which is why we have seen a shift from floating to fixed in the massive move in interest rates in the last few weeks,” Laila Kollmorgen, a managing director at PineBridge Investments, said in a telephone interview. “As Libor goes down over the next year, you are probably going to get wider spreads to keep yields high enough to attract investors.”

DOWNTURN READY

As managers prepare for a downturn, many are looking to purchase loans with higher credit ratings, accepting lower spreads in return, which only adds to CLO equity woes.

“In the event of a downturn, some low single B rated issuers will get downgraded to CCC, so firms need to manage how big that CCC spike could be,” Merrill said. “Managers are trying to get ahead of that, but that preparation puts a squeeze on the equity.”

Some managers have increased the amount of CCC rated loans their CLO can hold in anticipation of downgrades.

Z Capital Credit Partners earlier this year touted a new fund that offers the ability to invest up to 50% of its assets in Caa rated loans.

Recent CLOs allowed for about 7.5% of Caa rated assets, according to Moody’s Investors Service reports.

CLO participants say a number of new funds could be issued in the final months of 2019, but volume will be heavily dictated on market conditions and spreads.

“When you can get better stability in rates, and if we get a resolution to the trade war I think that would give us stability to move forward, but in an environment of higher volatility and uncertainty, wider spreads will be part of the outlook,” Kollmorgen said. (Reporting by Kristen Haunss. Editing by Michelle Sierra.)

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