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The US CLO market has been to hell and back in 2020. From the depths of the March sell-off, the sector has faced huge challenges but has seen a remarkable comeback. Bullish sentiment is back on for Q4, and that defines the outlook for 2021. Not all managers will be well placed to take advantage, however, and a wave of consolidation probably looms. By Paola Aurisicchio.

All’s well that ends well — for the US CLO market, at least. New deal supply managed to resume a steady pace into year end, with triple-As breaking new post-pandemic tights and managers rushing to market. CLOs have benefited from a broad rally in credit, though the Federal Reserve’s intended direct support for the market, though the Term Asset Backed Securities Loan Facility (TALF), proved a damp squib.

2020 is set to end with more than $75bn of supply, according to Wells Fargo — a positive surprise, given that the market was in turmoil for a large part of the second quarter. This level is still a long way below the record volume of $129.3bn in 2018, or the $119bn seen in 2019.

As the year progressed, spreads on triple-A tranches tightened back in from 190bp or so to almost pre-Covid levels, the rating agencies slowed the pace of their leveraged loan downgrades and triple-A buyers got their investment appetite back.

That has encouraged market players to predict improving supply next year, with analysts at Barclays and JP Morgan expecting $90bn-$100bn in primary issuance.

Tighter, bigger, better

Triple-A spreads “will continue to tighten along with the continued rise in loan prices,” says Dan Wohlberg, a director at Eagle Point Credit Management in Greenwich, Connecticut.

Clos For Dummies

The US congressional race and the progress of the pandemic will shape the strength of the market at the start of the new year.

Even after Joe Biden’s victory in the presidential election, the extent of the Democrats’ power will hang in the balance until control of the US Senate is determined in January.

With Republicans looking likely to hold the Senate and Democrats controlling the House, any new fiscal stimulus package will be smaller than it would be with a Democrat clean sweep. But it might also block any potential tax hikes, which could help the market.

“A split House and Senate would also diminish the probability and degree of potential tax hikes and spending increases, something that would be well received by the markets,” says Americo Cascella, co-founder and CEO of newly launched CLO management business Pacific & Plains Capital in Dallas, Texas. “That could engender increased M&A, more debt issuance to finance transactions, and by association more issuance of CLOs.”

If Democrats win control of both houses of the Congress, “we may see diminished incentive for investment and corporate sector activity, which could cascade down into lower issuance volume for the CLO market,” he says. “Overall, we think that the most likely case for the CLO market is to continue growing incrementally at mid-single digit pace over the medium to longer term.”

Recent amendments to the Volcker Rule — effective from October 1 — have also the potential to foster CLOs next year.

The Volcker rule amendment “is going to be very beneficial to the new CLO issuance because, among other changes, it enables CLOs to return to a 5% bond bucket. It means more room for securitization,” says Nathan Spanheimer, partner in Cadwalader’s capital markets group in Charlotte, North Carolina. “We are also continuing to see managers pushing for flexibility to make sure that CLOs are able to participate in workout scenarios and can take advantage of workout opportunities.”

According to the lawyer, these two factors will also help investor appetite by making the CLO product more attractive.

Still short?

CLOs in 2021 are also likely to see a gradual return to longer reinvestment periods, which prevailed before the Covid crisis. When the pandemic hit, the volatile markets and threat of defaults made investors hesitant about buying bonds to fund a full five years of active management from the CLO manager.

Managers shifted structures to match, and the post-Covid era has seen a proliferation of deals with three year reinvestment periods, rather than the usual five.

But a handful of managers are now issuing with five year reinvestment periods again — First Eagle Alternative Credit, Onex Credit Partners and Bain Capital Credit, for example. As issuance rebounds in 2021 more CLOs are likely to push their reinvestment periods, but some believe shorter deals are here to stay in certain cases.

For Wohlberg, the trend is back to five year reinvestment periods with a commensurately longer non-call (two years), but he also says that shorter duration reinvestment periods are likely to stay into next year.

“Some investors may opt to trade off the reinvestment period for non-call or use the shorter duration in reset transactions, where it may be preferable in the structure. Overall, it will continue to be an option for investors,” Wohlberg notes.

Cascella of Pacific & Plains also believes that, in the absence of another economic downturn or shock, “we should see a continued move back toward the historically more traditional five year reinvestment structure as the year goes on. We also think that, increasingly, debt and equity investors are less enthusiastic about having to renew their portfolio constantly.”

Wave of consolidation

Tough times — such as the second quarter of 2020 — act as a proving ground for CLO managers, and this could point the way to consolidation. Successful credit picking and trading out of underperforming loans always matters, but the volatility in 2020, as well as the wave of loan downgrades and restructurings, have made manager performance more crucial than ever.

Even as market prices have bounced back a long way, the percentage of triple-C loans remains high. Some 21% of outstanding deals failed at least one overcollateralisation test, according to Bank of America estimates in May, the peak of the downgrades.

Some managers have yet to venture into the post-Covid market at all with new deals, perhaps as a result of constraints on equity supply as well as performance issues.

Barclays analysts counted 73 broadly syndicated loan CLO managers that have priced a new deal in 2020, according to a mid-November report, some way behind the 89 managers that went to market in 2019.

In 2021, the performance challenges of 2020 will add additional stress on managers, with larger or more experienced shops which remain active in primary, or small managers with a strong differentiating brand, likely to benefit. That might allow some larger platforms to buy their smaller competitors.

“We expect consolidation among CLO managers, especially in the second half of 2021. The CLO market will continue to bifurcate between very large firms with platforms and specialist firms coming into the market with a clear focus and innovation; that, for us, is technology and ESG,” says Daniel Hall, co-founder of Pacific & Plains Capital.

Performance and pricing

Hall points out that “managers that may have performance issues will likely have a more difficult time raising capital and securing competitive debt pricing. We believe that those distressed managers will be the most likely candidates for acquisition as the year progresses.”

Shane Mengel, fellow co-founder and CIO at Pacific & Plains, says: “The disruption caused by Covid-19 acted as a strong market stress test. It provided a lot of insight into the manager spectrum and, in particular, manager differentiation to give investors a base around which to evaluate performance and to determine future capital allocations.”

Performance issues aren’t over, either, with default rates expected to rise and loan downgrades likely.

S&P Global expects as a base case that default rates will increase to 8% by June 2021. In its optimistic scenario, the rating agency forecasts that default rates will fall to 2.5% through June 2021; in its most negative scenario, S&P predicts that the default rate will rise above the all-time high to 9.5% by next June.

The default rate remains a key concern of 2021. CLO managers, on the other side, have learned something by the first wave of negative actions.

Clouds

“The market has been working to make CLOs better holders of stressed assets to allow CLO managers to best work out of legacy positions,” Wohlberg says.

“We have seen some levelling out in defaults recently and, more importantly, today CLO managers have a better understanding of Covid-related stress and its effect on certain sectors and issuers to forecast concerns.” GC

Collateralized loan obligations (CLOs) are a form of securitization where payments from multiple middle sized and large business loans are pooled together and passed on to different classes of owners in various tranches. A CLO is a type of collateralized debt obligation.

Clover

Leveraging[edit]

Each class of owner may receive larger yields in exchange for being the first in line to risk losing money if the businesses fail to repay the loans that a CLO has purchased. The actual loans used are multimillion-dollar loans to either privately or publicly owned enterprises. Known as syndicated loans and originated by a lead bank with the intention of the majority of the loans being immediately 'syndicated', or sold, to the collateralized loan obligation owners. The lead bank retains a minority amount of the loan while usually maintaining 'agent' responsibilities representing the interests of the syndicate of CLOs as well as servicing the loan payments to the syndicate (though the lead bank can designate another bank to assume the agent bank role upon syndication closing). The loans are usually termed 'high risk', 'high yield', or 'leveraged', that is, loans to companies which owe an above average amount of money for their size and kind of business, usually because a new business owner has borrowed funds against the business to purchase it (known as a 'leveraged buyout'), because the business has borrowed funds to buy another business, or because the enterprise borrowed funds to pay a dividend to equity owners.

Rationale[edit]

The reason behind the creation of CLOs was to increase the supply of willing business lenders, so as to lower the price (interest costs) of loans to businesses and to allow banks more often to immediately sell loans to external investor/lenders so as to facilitate the lending of money to business clients and earn fees with little to no risk to themselves. CLOs accomplish this through a 'tranche' structure. Instead of a regular lending situation where a lender can earn a fixed interest rate but be at risk for a loss if the business does not repay the loan, CLOs combine multiple loans but do not transmit the loan payments equally to the CLO owners. Instead, the owners are divided into different classes, called 'tranches', with each class entitled to more of the interest payments than the next, but with them being ahead in line in absorbing any losses amongst the loan group due to the failure of the businesses to repay. Normally a leveraged loan would have an interest rate set to float above the three-month LIBOR (London Inter-bank Offered Rate), but potentially only a certain lender would feel comfortable with the risk of loss associated with a single, financially leveraged borrower. By pooling multiple loans and dividing them into tranches, in effect multiple loans are created, with relatively safe ones being paid lower interest rates (designed to appeal to conservative investors), and higher risk ones appealing to higher risk investors (by offering a higher interest rate). The whole point is to lower the cost of money to businesses by increasing the supply of lenders (attracting both conservative and risk taking lenders).

CLOs were created because the same 'tranching' structure was invented and proven to work for home mortgages in the early 1980s. Very early on, pools of residential home mortgages were turned into different tranches of bonds to appeal to various forms of investors. Corporations with good credit ratings were already able to borrow cheaply with bonds, but those that could not had to borrow from banks at higher costs. The CLO created a means by which companies with weaker credit ratings could borrow from institutions other than banks, lowering the overall cost of money to them.

Demand[edit]

As a result of the subprime mortgage crisis, the demand for lending money either in the form of mortgage bonds or CLOs almost ground to a halt, with negligible issuance in 2008 and 2009.^[1]

The market for U.S. collateralized loan obligations was truly reborn in 2012, however, hitting $55.2 billion, with new-issue CLO volume quadrupling from the previous year, according to data from Royal Bank of Scotland analysts. Big names such as Barclays, RBS and Nomura launched their first deals since before the credit crisis; and smaller names such as Onex, Valcour, Kramer Van Kirk, and Och Ziff ventured for the first ever time into the CLO market, reflecting the rebounding of market confidence in CLOs as an investment vehicle.^[2] CLO issuance has soared since then, culminating in full-year 2013 CLO issuance in the U.S. of $81.9 billion, the most since the pre-Lehman era of 2006-2007, as a combination of rising interest rates and below-trend default rates drew significant amounts of capital to the leveraged loan asset class.^[3]

The US CLO market picked up even more steam in 2014, with $124.1 billion in issuance, easily surpassing the prior record of $97 billion in 2006.^[4]

Risk retention[edit]

In 2015, however, the volume of CLOs issued lowered as investors eyed new risk-retention rules scheduled to go into effect at the end of 2016.^[5] These rules, among other items, require managers to retain 5% of the entire size of the CLO.^[6]Consequently, CLO issuance slipped to a still-healthy^{[clarification needed]} $97.34 billion in 2015, though it slowed considerably at the tail end of the year, and all but shut down in the early months of 2016, as the leveraged loan market battled investor resistance to risk in general, amid plunging oil prices.^[7] In response to the risk-retention rules, Sancus Capital Management developed the Applicable Margin Reset (AMR) protocol, which obviated the need to comply with the risk-retention rules for transactions issued prior to December 2016.^[8] However, in February 2018 the US Court of Appeals for the District of Columbia Circuit ruled that CLO managers no longer need to comply with the 5% risk-retention rules.^[9][10]

See also[edit]

Clodeo

• Collateralized debt obligation, securitization vehicle for various debt instruments
• Collateralized fund obligation, securitization vehicle for private equity and hedge fund assets
• Collateralized mortgage obligation, securitization vehicle for residential mortgages

References[edit]

1. ^'CLOs/Institutional Investors'. Leveraged Loan Primer | LCD.
2. ^http://www.creditflux.com/Newsletter/2012-08-02/Citi-leads-charge-as-CLO-volumes-surge-past-last-yearrsquos-tally/
3. ^Miller, Steve (2014-01-02). '2013 CLO Issuance Hits $81.9B; Most Since 2007'. Forbes.
4. ^Husband, Sarah. 'U.S. CLO market prints record $123.6B of new issuance in 2014'.
5. ^'Leveraged Loans: 2016 CLO Outlook – Credit Concerns and Risk Retention in Focus'.
6. ^'Credit Risk Retention'(PDF). Office of the Comptroller of the Currency.
7. ^'Loan Market Primer: CLOs'.
8. ^Temperlo, John M. (September 1, 2016). 'Letter to the SEC on Behalf of Sancus Capital Management LP'(PDF). Division of Corporation Finance Securities and Exchange Commission. Retrieved 9 July 2020.
9. ^Haunss, Kristen (11 May 2018). 'CLO risk retention now just a memory as final appeal deadline passes'. Reuters. Retrieved 9 July 2020.
10. ^Pearlstein, Steven (July 27, 2018). 'The Junk Debt That Tanked the Economy? It's Back in a Big Way'. The Washington Post. Retrieved 9 July 2020.

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