As markets kick off the last third of the year, there is likely a shortened window for CLO issuance, given the presidential election in November. This has spurred market participants to feel bullish about prospects for new CLO supply. Indeed, forecasts are for a breathless few months of CLO creation, which is a boon as CLO deal count and volume is currently down 36% and 43% on this time last year, at 111 new issues for $48.2 billion. Any pick-up in supply comes against a backdrop of tightening liabilities, but also an improvement in the state of outstanding vintages.
“We are being warmed up for a pick-up in supply,” notes a CLO liability investor. “We are still cautious but technicals have improved and should support new supply.”
“I have spoken to a few arrangers and they have decent pipes,” says a liability and equity investor. “They have already covered the majority equity, so they will get done.”
“Based on rating agency reports, and conversations with investors and CLO managers, post-Labor Day CLO issuance is expected to be very heavy,” writes David Preston and the research team at Wells Fargo this week. “We see two primary causes for the rush to issuance. First, managers want to issue before volatility increases as the U.S. election nears. Second, CLO liability spreads have finally tightened, making issuance more economical.”
“Since early June we have experienced a steady, continued increase in new instructions and new warehouses opening,” comments the research team at Maples Group. “From early/mid-June onwards, those new instructions have led to an additional 15 or so open warehouses.” The team also speaks of there being 70-plus warehouses open.
The forecast for more new issuance is largely due to lower liability costs, with the average primary triple-A spread tightening to 174 bps in August from 218 bps in April, according to LCD. Moreover, Blackstone/GSO set a post-covid tight on the triple-As last month of 130 bps, and Bain Capital Credit yesterday set the second tightest at 138 bps.
Moreover, further CLO tightening is expected. Maggie Wang and the team at Citi this week commented that “Top-tier managers have led the primary CLO AAA tightening and priced inside L+140 bps. But second-tier primary CLO AAA spread is still lagging the secondary market rally. We expect top tier primary AAA spread to tighten to L+120 bps by YE.”
Citi also points out that over half of US CLO managers with less than $5 billion of AUM have yet to issue, but the largest 20% of managers, with over $10 billion of AUM combined, increased market share by 2% to 51%.
It may well be that the smaller managers look to keep their franchises ticking over with at least one new issue before year-end. Certainly many will be keen to do so, but liability investors warn that getting the equity placed will be hard for them, unless they have access to affiliated equity.
“We don’t think CLO equity makes a lot of sense at the moment, and nor do other third-party providers,” comments a CLO equity investor. “Having said that, some of the smaller managers have been pretty conservative and have performed well. It is an approach that will work today. They can get the debt done, but can they get the equity?”
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Blowin' in the wind
Tighter liabilities and pent-up issuance are not the only factors likely to boost supply. While significant challenges remain, wider market headwinds are subsiding, at least for now.
Rewind a few months, and there was understandably much concern about how CLOs were going to navigate the corona-crisis. Streams of leveraged loan downgrades led to a sizeable proportion of CLO mezz notes being downgraded or being put on review for downgrade. Moreover, CLO test failures picked up markedly, and many in the market braced themselves for pain.
The backdrop now, though, offers less cause for alarm.
“U.S. CLOs improved OC cushion in August…. only 15% of U.S. CLOs — and 9% of reinvesting U.S. CLOs are currently failing an OC test,” wrote David Preston and his Wells Fargo research team earlier this month. “Thus far in Q3, 2.4% of U.S. Broadly Syndicated Loan (BSL) CLO tranches deferred interest (PIK’d).”
This is a notable improvement to May, when Wells Fargo had 20% of reinvesting CLOs failing an OC test, versus 9% in August.
Meanwhile, in a research note published Sept. 4, S&P Global Ratings observed a decrease in triple-C buckets and an increase in CLO tranches that were removed from CreditWatch negative.
"While we are far from seeing a 'wave' of corporate upgrades, in August, we saw some positive signs" analysts wrote.
In August, average 'CCC' buckets across its CLO Insights 2020 Index declined to 10.17%, which S&P Global Ratings attributed to one upgrade for LTI Holding to B-, from CCC+, and seven issuers rated B- that were removed from CreditWatch negative (those CLOs previously had to be treated as triple-C obligations).
"The net effect of the other rating actions 'B-' and above have also resulted in the gradual improvement in SPWARF (which measures CLO collateral average ratings) in August, which is now within a stone's throw from falling below 2900, a level not seen since early April" analysts wrote.
In terms of CLO tranche ratings, out of the total of 597 U.S. CLO ratings that were placed on CreditWatch with negative implications due to the impact of COVID-19 on the corporate credit markets, S&P Global Ratings noted as of Sept. 3 that it had resolved 458 of them.
In an update to its mid-June "US CLO Warehouse – COVID-19 Health Check" report, Maples highlighted new data on Sept. 8, which further supported the view that US CLO warehouse arrangements had remained resilient.
Reporting in June that around 75% of warehouses appeared to be unaffected by the downward pressure on leveraged loan prices, Maples noted that since then, over 16% of those warehouses had successfully reached CLO close, with around 5% of additional deals having priced or were looking to price imminently.
In addition, from June onwards, Maples Group also observed that "very few" additional warehouses had entered into difficulty or were terminated, while of the 25% of 'symptomatic warehouses' exhibiting signs of being 'underwater' during the first period of analysis, remedial actions or terminations have now, for the most part, occurred.
Maples also noted that managers had been quick to adapt to the new environment, employing tactics such as splitting and downsizing deals or combining deals to create viable portfolios.
"All of this bodes well for the uncertain times ahead and, with relatively little trepidation, we can conclude from our data that there are signs for optimism as the market adjusts."
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