01/11/2013

CLO Issuers Wring Hands Over Asset Prices

Worries are surfacing among managers of collateralized loan obligations that rising prices among the loans backing their offerings could put a crimp on profits, potentially bogging down deal production.

While leveraged-loan prices have been climbing for some time, a fresh round of increases this month is causing issuers to grumble that it’s becoming harder to capture arbitrage between the yields on those assets and the smaller returns paid to CLO buyers. Eventually, certain deals could become uneconomical.

But that’s just one possible scenario, and a long-term one at that. With investors rushing to gain exposure to leveraged loans via CLOs, the consensus is that issuance volume will continue to grow at a healthy rate for the foreseeable future. For example, Bank of America researchers predict that $75 billion of CLOs will hit the market in 2013, with Citigroup weighing in with a forecast of up to $65 billion and J.P. Morgan making a call of up to $70 billion — all substantially higher than the $55.7 billion of deals that priced in 2012, according to Asset-Backed Alert’s ABS Database.

Last year’s activity, in turn, marked a breakout from the 2011 total of $12.9 billion.

It’s difficult to say exactly what it would take to sap the arbitrage from CLOs, which at least for the moment remain one of the hottest types of structured products. Leveraged-loan prices are the predominant side of the equation. Even as lending volume rose to a post-credit-crisis high last year, demand from CLO managers and other buyers increased even more rapidly. The upshot: loan prices shot up, especially during the second half. The pattern continued during the first week of this year, with the S&P/LSTA Leverage Loan Index tacking on 119 bp from Jan. 1 to Jan. 9 to close at 97.28 cents on the dollar.

That marks a full recovery in values from the credit crisis, which saw the index sink as low as 59 cents on the dollar.

Amid tepid buyout activity, leveraged-loan production has been driven largely by borrowers that want to refinance existing debt at lower interest rates, adjust the maturities of their debt or pay dividends to shareholders. Demand for those loans, meanwhile, has been motivated largely by a desire among CLO managers, mutual fund operators and other investors to find higher-yielding debt products.

As far as funding costs are concerned, spreads on the triple-A-rated classes of new deals have held more or less steady around 140 bp over three-month Libor in recent months. Looking forward, they are seen as likely to come in as investors keep flooding into the sector. Demand for CLO equity has been healthy as well.

The question is how much loan prices will rise from here, and whether CLO spreads can tighten enough to keep ahead of those increases. “If you are competing to ramp up with 25 other CLOs, and you have to pay a higher dollar price, and you get squeezed on the spread, that’s where things get difficult,” one source said. “We’re not there yet. We are watching it.”

Meanwhile, some underwriters are holding out hope that CLO spreads will tighten to levels that would preserve managers’ arbitrage before dealflow takes a hit — while acknowledging that challenges are beginning to surface. “I think we’ll have a big January,” one banker said. “Arb is always something we have to grapple with and loan prices have been rising. That’s been a one-way trend. Liabilities have not tightened, but we are starting to see some liability tightening as is usually the case. If there is no arb, there will be no deals.”

One possibility: Issuance could come in fits and starts as loan prices and CLO spreads fall in and out of balance. “The concerns are real,” the underwriter said. “I think you will see a lot of issuance, but it will potentially not be uniform throughout the year.”

In fact, uncertainty about arbitrage and regulatory pressures could lead to spurts in deal production as managers hurry to wrap up deals. “There is a good chance there is a window that is closing, so if you are a manager relying on a fee business you want to get in as many as you can. They might be buying themselves five more years of relevancy,” one issuer said, referring to the fees that a manager collects for overseeing a CLO over the life of the transaction.

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