March 28, 2019 - The 2019 topline CLO numbers look surprisingly robust. New CLO issuance has topped $25 billion, off around 15% from 2018 figures, while there’s just been one fewer deal than last year, Wells notes. But beneath these unremarkable numbers lies considerable drama.

First, LCD points out volumes and pipelines are high, in part, because there is a large backlog of warehouses open that look to be cleared. Second, it is hard to clear this pipeline because the arbitrage between assets and liabilities is even more challenging than usual. Barclays observes that in new CLOs, loan asset spreads have edged down to LIB+351, while CLO Weighted Average Cost of Capital has increased to LIB+196. This tightens the arbitrage to 155 bps, around the lowest level seen since 2015. Third, there’s Japanese Risk Retention (JRR). While Japanese investors are continuing to invest, the potential imposition of risk retention (and requirement for more loan information) creates some uncertainty.

And then there’s the interest rate environment. LCD pointed out that for years investors have been drawn to floating rate products (like loans, CLOs and loan mutual funds) with the expectation that interest rates will rise. As sentiment has shifted from rate rises to rate cuts, investor interest has shifted toward fixed rate products. In turn, loan mutual funds have seen more than $8 billion of outflows, while HY bond funds have enjoyed more than $10 billion of inflows, Nomura reported. Responding to this demand dynamic, more issuers are switching their funding needs away from loans and into bonds. And, finally, demand for floating rate CLO notes is easing, Wells observed.

All these challenges beget creative solutions – and economic ones. Strategy #1: Shorter deals. Barclays noted that more than 25% of CLOs this year have had reinvestment periods of less than four years; last year that figure was around 10%. Strategy #2: Introducing fixed rate notes. LCD calculated that 31% of CLOs this year have offered a fixed rate tranche, up from 23% in 2018 and 16% in 2017. Strategy #3: Squeezing fees (further). LCD anecdotally reported that some equity investors have been pressuring both managers and arranging banks to reduce their fees to close deals.

So what does all this mean for the CLO market? First, topline issuance trend might not change that much. Wells pointed out that there are a number of forces that could maintain new CLO supply in the near term. The large dedicated CLO equity funds raised to address US risk retention, combined with the growth of the manager base, argues for continued CLO issuance. Barclays is keeping its new issue BSL CLO forecast in the $100-110 billion range. But with CLO liabilities costs higher than they have been in years, Barclays expects reset activity to plummet. They are adjusting their reset forecast to $40-55 billion from $95-110 billion.  As for spreads? JPM notes that, at 142 bps, CLO AAA spreads have widened above Financials for the first time since early 2018. And they are expected to stay there: JPM’s Annual Survey suggests that AAA spreads will be in the LIB+134 bps context at year end.