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November 10, 2017  

Demand Sustaining CLO Spread Squeeze

Even with spreads on collateralized loan obligations steadily tightening for much of this year, managers keep looking for ways to further reduce their funding costs.

Prudential issued CLO paper this week that set a three-year investment period for the refunding of a 2013 deal. That’s shorter than the typical extension, or “re-set,” of four or five years, and gave investors additional comfort that left them willing to accept lower returns.

Working on Prudential’s behalf, bookrunner Credit Suisse on Nov. 7 priced the shorter triple-A rated senior notes to yield 82 bp over three-month Libor, about 30 bp tighter than a typical Prudential deal would have fetched.

Other managers are expected to follow suit. “There will be copy cats,” predicted one manager.

Strong demand for CLOs has led to predictions that spreads for triple-A rated senior notes with longer reinvestment periods will narrow to 100 bp or less in the coming months, after starting the year at 150 bp.

On Oct. 30, Barclays priced the senior notes of a $609 million deal for Voya Alternative Asset Management at 113 bp, the tightest of the year to that point. And deals are being talked even tighter.

“Things are moving pretty fast all of a sudden,” said one dealer. “The managers want to go tighter because they can. And the investors are along for the ride. Deals are oversubscribed from top to bottom.” The dealer said the shorter paper offered by Prudential is in great demand by large investors like Pimco and BlackRock, which prefer the shorter-term risks and have funds that are restricted to buying securities of certain durations.

The spread tightening is in the context of a broad supply-demand trend impacting most structured products. But it is a more urgent matter for CLO managers, who are facing widespread tightening on the loans that secure their bond offerings.

Some sources are predicting that loans to healthier below-investment grade companies will hit 200 bp over three-month Libor, which is about 50 bp narrower than at the start of this year.

At the annual conference of the Loan Syndications and Trading Association on Oct. 26, loan scarcity was a key topic of discussion, with participants predicting that the shortage and continued loan-spread tightening would continue for another year, barring a major unforeseen disruption.

Participants noted that about 75% of loans syndicated this year have been refinancings meant to furnish borrowers with lower funding costs. According to the LSTA, loans outstanding rose by about $55 billion this year, but that has been more than absorbed by a net increase of $30 billion in CLO paper, $20 billion in loan mutual funds and an unspecified increase in separately managed accounts, which are thought to total about $120 billion.

Some believe the industry may be caught in a vicious cycle: CLO managers refinance old deals to restore the arbitrage as loan spreads tighten, and in the process they put corporate borrowers in a strong position to demand even tighter spreads.

“It is a symbiotic relationship,” said the dealer. “Clearly as assets are tightening, you have to see liabilities tighten, or managers won’t be able to continue buying loans. In fact, people are having to change deal [parameters], because they are designed for higher spreads.”

The LSTA noted that loan spreads were much tighter before the credit crisis than they are now, with an expectation they could go still tighter next year. “Buckle up,” wrote Meredith Coffey, the LSTA’s head of research and analysis, in an Oct. 27 note to members.