Outlook 2016: CLO volume forecast to drop; risk retention weighs on markets; spreads widen

By Cristal Cody

Tupelo, Miss., Dec. 31 – CLO volume is predicted to drop in 2016 on a variety of headwinds, including lower loan issuance and risk retention regulations.

Still, the market is expected to stay strong with market analysts forecasting $60 billion to $80 billion of U.S. CLO broadly syndicated supply and €15 billion to €17.5 billion of euro-denominated CLO issuance for the year ahead.

While 2015 supply came in behind the record $124 billion of volume brought to market in 2014, the year’s totals were no slouch.

CLO managers priced more than $121 billion of global CLOs in 2015, including broadly syndicated, middle-market and refinancing transactions, according to market sources and Prospect News data.

More than $90 billion of broadly syndicated CLOs priced in the U.S. market in 2015, close to forecasts of about $100 billion of supply over the year.

In Europe, about €13.5 billion of broadly syndicated CLOs priced in 2015.

While 2014 was the year of several $1 billion-plus CLO deals, few deals hit that size in 2015.

The year saw two CLOs price with dual currency tranches and 25 refinanced vintage U.S. CLO deals and one refinanced European CLO transaction.

Supply in 2015 outpaced 2014 through the first five months of the year before slowing down in the second half, according to market analysts.

“Issuance over the first six months of the year totaled $60 [billion] and spreads steadily tightened across the capital structure,” Morgan Stanley & Co. LLC analysts said in a report. “However, issuance slowed significantly since July and spreads widened on global macro volatility as well as credit concerns, but CLOs proved more resilient than some other sectors of fixed income including CMBS and corporates that widened even more.”

Spreads widen

New issue CLO spreads widened over the year, particularly in the mezzanine tranches.

“We note increased tiering in AAA with deals pricing in a 15 to 20 [basis points] range,” the Morgan Stanley analysts said. “Deals brought by managers with more than 10 CLO 1.0 deals under management are pricing tighter than others.”

Compared to the end of 2014, US CLO AAA spreads are 13 bps weaker, according to BofA Merrill Lynch.

BBB spreads are 25 bps softer, BB spreads are 120 bps wider and B spreads are 205 bps wider on the year, BofA Merrill Lynch analysts said in a note.

CLO AAAs have ranged from around Libor plus 130 bps to Libor plus 168 bps year to date.

AA-rated notes have printed from Libor plus 190 bps to Libor plus 255 bps, while A spreads have ranged from Libor plus 285 bps to 355 bps in 2015.

BBB-rated tranches have softened from Libor plus 385 bps to 500 bps over the year. BB notes widened from Libor plus 615 bps to Libor plus 825 bps by the end of the year, according to BofA Merrill Lynch.

CLO B-rated notes ranged from Libor plus 785 bps to Libor plus 1,050 bps in 2015.

Spread forecasts

CLO spreads are not expected to change too much in the near-term.

“We think new issue AAA spreads will stay flat in the L+155-160 [bps] range through to midyear 2016 but as we go down the capital structure we anticipate some more credit curve steepening,” J.P. Morgan Securities LLC analysts said in a note. “While the technical picture appears positive with the 30-40% drop in supply, we believe the fundamental story will remain prominent and handicap spreads from tightening in.”

Wells Fargo Securities, LLC analysts forecast first-quarter 2016 AAA spreads at 150 bps to 155 bps from the current 160 bps area and BBB spreads 25 bps tighter at the 450 bps area.

BofA Merrill Lynch analysts said U.S. CLOs should see “at least partial spread retracement in the first half of 2016.”

Deutsche Bank Securities Inc. analyst Bjarni Torfason said in a note that at current wides, there is room for spreads to tighten.

“Rates could play a central role in that respect, pressing spreads generally tighter,” he said.

Euro CLO spreads are on average at similar levels or wider than levels at the start of the year, BofA Merrill Lynch analysts said.

“Market conditions are currently difficult for CLO new issuance, with spreads almost at their widest levels since the market restarted in 2013 for most of the capital structure, except for AAA bonds where spreads are wider than they have been for 2.0 deals,” BofA Merrill Lynch analysts said.

Pickup in deal volume on way

The first few months of the new year should see a pickup in U.S. CLO deals, according to Wells Fargo Securities analysts.

Market analysts do not expect a large number of refinancing transactions in 2016 until spreads improve.

“At the current wide spreads, there is clearly little incentive to get into refinancings, but should spreads tighten we could start seeing refinancings again,” Torfason said.

CLO deal structures in 2016 are not expected to change much, though a few features may be added, according to Moody’s Investors Service.

“Typical CLO portfolios will continue to be at least 90% comprised of first-lien, senior secured loans,” Moody’s said in a report. “Nonetheless, to increase their excess spread in a low-yield environment, some deals will include riskier assets whose spreads are higher than those of conventional first-lien senior secured loans. Such assets include SME credits, first-lien, last-out (FLLO) loans and lower-rated loans.”

Moody’s also said it expects more multi-currency deals in 2016, rated warehouses and additional refinancings or repricings of vintage European CLOs.

Risk retention limits primary

U.S. risk retention regulations under the Dodd-Frank Act that take effect in 2016 are expected to reduce the number of CLO managers.

“Under the rules, beginning in December 2016, managers will have to retain 5% of the risk in their CLOs, the cost of which will be sufficiently burdensome to restrict some managers’ ability to issue new deals,” Moody’s said in the report. “Although most managers will develop ways to comply, we expect some manager ownership changes, consolidation or exits from the market.”

In 2015, 85 managers priced CLO deals, with five of the managers being first-time issuers for the year, according to Wells Fargo Securities.

“Of the 105 managers that issued in 2014, 30 have not yet issued in 2015,” Wells Fargo analysts said in a note. “Increasing demand for risk retention compliant deals may have kept some managers from issuing in 2015, given that some managers may not have access to the capital needed to fund 5% of a CLO.”

The percentage of new issue U.S. CLOs that are compliant with the regulations is increasing ahead of the compliance date, according to J.P. Morgan Securities analysts.

“In 2015, we estimate 23 of 183, or 12.6% of new issue U.S. CLOs, are U.S. risk retention compliant,” the analysts said. “Of the U.S. CLOs that priced in November and December MTD, around 40% and 43%, respectively, are U.S. risk-retention compliant.”

Most 2016 deals are expected to be compliant with U.S. risk retention rules.

“We believe many U.S. CLO managers spent Q2 and Q3 finalizing risk retention plans, paving the way for most 2016 deals to be risk retention compliant,” the Wells Fargo analysts said.

In Europe, where retention regulations already are in effect, the CLO manager universe has been restricted over the past year.

“Although risk retention continues to provide a barrier to entry, several new managers are reportedly working on deals, and we expect to see more enter the market next year,” the BofA Merrill Lynch analysts said.

Modest growth in the number of European CLO managers is expected in 2016 with most new entrants expected to be U.S. firms, Moody’s said.

European CLO issuance started 2015 strong, then was almost nonexistent over the summer before awakening in the last two months of the year.

“Asset sourcing has been challenging and institutional loan volume is 30% less y-o-y,” J.P. Morgan Securities said. “The demand-side has been problematic as European CLO spreads have been dragged out from E+132 to E+155 [bps]. In 2016, CLO funding economics will need to improve for higher issuance.”

Manager tiering in secondary

Manager tiering also continues to be a theme in the CLO secondary markets.

“There has been notable dispersion in new issue AAA levels across recent deals, depending on the collateral manager, and secondary valuations continue to be primarily driven by a combination of manager quality and the amount of commodity exposure in the collateral,” Barclays analysts said.

The CLO secondary market was fairly active in 2015.

“There were particular spurts of bid list activity in the spring as spreads tightened and then again in September and October as spreads widened sharply amid global tremors,” Torfason said.

U.S. CLO secondary 2.0 AAA spreads trade in the 160 bps context for Volcker-compliant paper, according to Morgan Stanley.

“Trading levels are even wider for non-Volcker-compliant paper, at 180 [bps] context if the portfolios don’t hold bonds and 190 [bps] context if they do, primarily driven by lower liquidity of these bonds,” Morgan Stanley analysts said.

© 2015 Prospect News.
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