Outlook 2018: Strong CLO new issue, refinancing volume forecast in United States, Europe

By Cristal Cody

Tupelo, Miss., Dec. 29 – Broadly syndicated CLO deal action is expected to continue at a strong pace in 2018 after volume was heavier than initially expected in 2017.

Wells Fargo Securities, LLC CLO analysts predict $125 billion of new issuance in 2018.

“Entering 2018, the U.S. CLO market faces combined headwinds of deteriorating credit fundamentals and an increased supply of CLOs and of competing products – all while spreads are at post-crisis tights,” the analysts said in a note. “Increased floating-rate demand and flat to higher all-in yields offset these headwinds in 2017.”

The CLO market faces several key themes in 2018, including increased supply of investment-grade fixed income assets, increased floating-rate demand, less tiering in spread levels by managers and higher leverage in loans, after two years of flat leverage, the Wells Fargo analysts said.

BofA Merrill Lynch CLO market analysts forecast $110 billion of volume in 2018.

“Our call for another year of $100+[billion] of issuance is based on our conviction that 2018 conditions will mirror that seen for much of 2017,” the analysts said in a research note. “We have crossed over enough uncertainty roadblocks on both the macro and regulatory fronts over the past few years, and got to a point where the picture is clear (and bright) enough for us to believe that a simple extrapolation of this year's result is an appropriate strategy.”

The Libor is expected to increase by 1% by the end of the third quarter of 2018, which should “further boost demand for CLOs,” according to the note.

The impact from U.S. tax reform was hard to call for market participants since the vote came late in December.

“Given the uncertainties surrounding the tax reform timeline, we stand by our $110 [billion] forecast for 2018, but acknowledge that smoother-than expected tax reform poses a downside risk,” the BofA Merrill Lynch analysts said.

“If we learned anything from the past few years about forecasting supply, it is the tendency for CLO issuance to surprise to the upside,” the analysts said. “The final new-issue tally of $126 [billion], $98 [billion], $71 [billion] and $100+ [billion] for 2014-2017, respectively, ended up being 30-40% higher on average relative to the market's year-ahead expectations.”

Market analysts had initially expected about $50 billion to $60 billion of volume in 2017.

Morgan Stanley forecasts $200 billion of U.S. CLO issuance in 2018, which also includes about $100 billion in refinancing of existing deals.

Refinancing record

CLO managers refinanced nearly $170 billion of vintage CLOs in 2017, the highest volume on record, market sources report.

Counting refinancings, resets and new issue CLOs, buyers of U.S. CLOs purchased more than $250 billion in 2017, according to the Wells Fargo report.

Refinancing activity is forecast to continue at a heavy pace in 2018 but lighter than the record amount in 2017.

Morgan Stanley analysts forecast 2018 CLO refinancing and reset volume to drop 40% from 2017’s record volume.

Fitch Ratings said in its 2018 structured finance outlook that “CLO resets and refinancings are likely to continue in 2018 with the same intensity as seen in 2017. This activity would be propelled mostly by 2015 and 2016 vintage CLOs, which have just reached or are nearing the end of their non-call periods.”

By the end of the first half of 2018, $222 billion in post-crisis CLOs will be callable, Wells Fargo reports.

“The 2015 and 2016 vintages that are callable by the end of H1 2018 have median AAA coupons of 147 [basis points] and 158 bps, respectively, or about 30-40 bps higher than current primary AAA spreads,” the Wells Fargo analysts said.

European supply picks up

Euro-denominated supply is expected to continue to climb over the new year after volume increased in 2017.

More than €20 billion of new euro-denominated CLOs priced, while another €23 billion of existing European CLOs were refinanced and/or reset in 2017.

In 2016, €16.5 billion of new European CLOs came to the primary market.

Wells Fargo analysts forecast €17.5 billion of new euro-denominated CLO issuance in 2018.

Volume “increased from 2015-2016 and looks poised to post another year of growth,” according to the Wells Fargo note. “Given the amount of liquidity in the euro credit markets, and the recent loan refi wave, we do not see credit concerns in the near term.”

Morgan Stanley analysts forecast €20 billion of European new issue volume and €24 billion of refinancing/reset supply in 2018.

“Next year, we see another €16 [billion] in deals coming out of their non-call for the first time, and there is another €3 [billion] from deals that are already out of non-call waiting to be refinanced,” the Morgan Stanley analysts said. “We also expect some second-time refinancings (a few of which happened in 2017 already) through being called by liquidation/rolling into new deal or refi with cheaper debt financings.”

CLO trends

The CLO market has “limited uncertainty” for the first time in years, including in December 2016 when risk retention rules took effect, according to the BofA Merrill Lynch analysts.

“On the CLO front, 90+ managers having proven themselves to be capable to comply with risk retention rules so far this year, and we expect their presence in the market to remain at similar levels,” the BofA Merrill Lynch analysts said.

Deal sizes likely will remain large in 2018, according to the Morgan Stanley analysts.

In 2017, U.S. CLOs saw an increase in size and a prevalence of deals with a five-year reinvestment period, while the use of a B-rated tranches eased compared to 2014 and 2015, the analysts said.

“Next year, it is likely that deal sizes will remain larger than those in previous years, and there will be continued issuance of deals with five-year reinvestment, but we do not foresee an increase in structural leverage or a significant pick-up in single-B tranche issuance,” the analysts said.

The market does face some potential issues in 2018, according to a Fitch Ratings report.

“Regulatory changes will be in focus, and could change market dynamics,” Fitch said. “The US Leveraged Loan Guidance might be subject to a congressional review, CLO managers may see lessened retain risk requirements, and a replacement for London interbank offered rate will progress in 2018.”

Spread action

U.S. dollar-denominated CLO AAA spreads are expected to continue to firm in 2018 after grinding tighter over the back half of 2017.

New issue spreads began 2017 in the Libor plus 142 bps area on average and had tightened to the Libor plus 110 bps area in December, with several issuers pricing the senior tranche as tight as Libor plus 107 bps, the BofA Merrill Lynch analysts said.

By November, primary CLO spreads were at or near post-crisis tights, Wells Fargo analysts reported. AAAs were in the Libor plus 115 bps area, AAs at Libor plus 140 bps, As at Libor plus 170 bps, BBBs at Libor plus 250 bps and BBBs at the Libor plus 250 bps area.

AAA-rated spreads tightened 8 bps between June and November, while BBs came in 110 bps, according to Wells Fargo.

“The story of 2017 has been unprecedented tightening in single-A through BB tranches,” the analysts said. “We believe new overseas investors and domestic corporate buyers increasing allocations to CLO tranches drove much of the new demand for single-A and BBB tranches.”

BofA Merrill Lynch analysts forecast new issue AAA spreads to tighten to the 90 bps to 95 bps area in 2018.

Morgan Stanley forecasts AAAs to firm to the Libor plus 100 bps area in 2018.

In addition, “U.S. CLO mezz tranches may continue to see firm bids, but we expect the U.S. CLO mezz term structure to moderately bear steepen over the course of 2018, with new issue U.S. BBB paper mean reverting to +325 bps,” the Morgan Stanley analysts said.

In Europe, CLO spreads tightened to post-crisis tights in 2017, and spread widening is expected to be limited in 2018, market analysts report. European AAAs reached a post-crisis tight with CVC Capital Partners Ltd.’s CVC Cordatus Loan Fund X DAC pricing in December at Euribor plus 72 bps.

“If we learned anything from the past few years about forecasting supply, it is the tendency for CLO issuance to surprise to the upside.” – BofA Merrill Lynch analysts in a report

“Regulatory changes will be in focus, and could change market dynamics.” – Fitch Ratings in a report on the CLO market

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