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May 15, 2020  

As Downgrades Ease, CLOs Spring Anew

With investor demand rebounding, more collateralized loan obligation issuers are rolling out deals.

At least nine CLOs were in the works this week, with the managers partly seeking to take advantage of lower funding costs that have come with a sharp tightening of spreads for the junior portions of their deals. Two of the deals priced, from Onex Credit and Owl Rock Capital.

Issuers also are finding more demand for their senior notes, with some big U.S. banks and insurers returning after recently pausing their purchases. There even is talk that some Japanese banks, one of the largest classes of buyers for senior CLO paper, are ready to put money to work for the first time since the coronavirus crisis began.

This week’s dealflow marks a vast increase from the week of May 4, when just two CLOs totaling $607 million priced. And the sector saw only 13 transactions for $4.5 billion during the entire month of April.

Of particular note is the presence of a three-year investment period in a $495.8 million transaction that Octagon Credit floated this week with Wells Fargo as the structuring agent and an offering that BlackRock is preparing via Goldman Sachs. Most CLOs issued in recent weeks had one-year reinvestment windows.

Longer reinvestment periods typically are a sign of investors’ confidence in the long-term health of CLOs and their underlying corporate loans, with four- or five-year periods the norm in better times. “If you see two three-year deals print, that’s not a bad sign,” one issuer said.

The willingness among buysiders to pick up subordinate paper in part reflects a recent moderation in loan downgrades, which had been putting serious pressure on junior positions. “We were at a place in April where, every week, our triple-C baskets were up by two percentage points and it felt like it was just going to continue,” one issuer said, referring to loans whose ratings were cut to the lowest permissible levels. “Now [the rating agencies] have stopped.”

Relatively benign first-quarter earnings from a number of below-investment-grade companies also helped bolster market sentiment.

The upshot is that a few buyers emerged late last week for thinly traded CLO notes rated double-B and triple-B. And that’s all it took for spreads to contract quickly. Triple-B notes from deals still in their reinvestment periods are changing hands today at the equivalent of 500 bp over three-month Libor. That compares to 595 bp at the end of April and 675 bp in early March.

Spreads on triple-A-rated CLO notes, meanwhile, have held steady over the past two weeks at 190-200 bp over Libor. But they already had recovered much of the ground they gave up in March, when they were trading wider than 400 bp.

With funding costs lower and loans still cheap, collateral managers see a window of opportunity. To that end, a large portion of the CLOs currently in the market are following a print-and-sprint format in which the managers quickly deploy deal proceeds to buy loans, as opposed to warehousing assets ahead of time.

The window may be short-lived, however, as there are signs that loan yields are about to fall and thus reduce the potential arbitrage between those holdings and the lower returns paid to investors in new CLOs. For example, Bass Pro’s Term B loan, with a “B1” grade from Moody’s, changed hands at 86.5 cents on the dollar last week and now is attracting bids of 91 cents.

A recovery in loan prices would benefit existing CLOs, however. That’s because the recent corporate downgrades caused many deals to exceed their limits for holdings of triple-C-rated loans, meaning they must mark to market any excess low-rated loans when calculating over-collateralization. And the higher a loan trades in the secondary market, the less likely a CLO’s over-collateralization will fall to the point where it has to divert or shut off payments to equity holders.

That said, Moody’s, S&P and Fitch still are reviewing numerous loans for rating reductions. And many deals already have had to divert at least some payments away from equity investors.

What’s more, the population of investors willing to put money to work in the equity portions of new deals remains small. That limits issuing opportunities to managers that can retain their own equity.

But even there, some signs of a thaw have emerged. “We’re having more productive conversations with equity investors,” one issuer said. “That’s a big change from a month ago, when they wouldn’t even have called us. Now it’s ‘what are you thinking? What structures make sense?’ ”

What about a May 12 update to the Federal Reserve’s Term Asset-Backed Securities Loan Facility that seems to open the door to more funding of CLOs? The early feedback is that industry participants still see the emergency program as unworkable for their deals.

In a report the same day, Morgan Stanley said the central bank’s clarification that eligible CLOs could contain collateral dated as far back as Jan. 1, 2019, instead of this March, could theoretically enable issuers to clear out warehouse lines and free up capital for new lending. But given an interest rate of 125 bp over swaps for TALF financing, a continuing prohibition on deals with revolving collateral pools and various portfolio limitations, the bank sees the appeal for the broader CLO market as limited.