Outlook 2017: U.S CLO volume forecast to drop slightly; Euro CLO supply to rise; spreads to firm

By Cristal Cody

Eureka Springs, Ark., Dec. 30 – U.S. CLO deal volume is expected to decline modestly in 2017, while European primary action is forecast to increase.

Deal volume over 2016 dropped from the previous year, with the exception of refinanced CLOs and European issuance.

“U.S. CLO supply has declined for three consecutive years,” according to J.P. Morgan Securities analysts. “Drivers of this trend include volatility, loan market conditions, demand for CLO equity, changes in risk-based capital and rating methodologies, competing refi/reset supply, and regulation. After rapidly growing earlier this cycle the market is gravitating toward a more sustainable ‘new normal,’ in our view.”

Primary action was “ambitious” in the fourth quarter, but a “slowdown” is expected in the first quarter of 2017, according to Wells Fargo Securities LLC analysts in a report.

“On the supply side, after four years of consistent market growth, the CLO market decreased in size in 2016,” the analysts said. “We forecast $70 billion of gross U.S. CLO issuance in 2017.”

Moody’s Investors Service said in its 2017 forecast report that it expects U.S. CLO issuance in 2017 to “start slowly but to eventually reach a total comparable to that of 2016. Refinancings of existing CLOs will remain active.”

In 2017, demand is expected to increase for floating-rate assets as the Federal Reserve continues tightening and more government spending is anticipated under a Donald Trump presidency, according to market participants.

“We forecast spread tightening in Q1, due to lower supply and a risk on sentiment (barring a euro zone political surprise),” the Wells Fargo Securities analysts said.

CLO spreads are widely expected to tighten over the new year.

“Most investors expect U.S. CLO aggregate spreads to tighten in three and six months,” BofA Merrill Lynch analysts said in a forecast report. “The results differed in terms of where spreads would be in 12 months depending on whether the responses were collected before or after the U.S. presidential election. Most investors responding to the survey after the election thought spreads would widen in 12 months.”

BofA Merrill Lynch analysts forecast about $54 billion of U.S. CLO supply in 2017.

Forecasting for 2017 is difficult for many in the marketplace under a Trump presidency.

“As we think about 2017, the supply picture is one of the biggest question marks,” the JPMorgan analysts said in a report. “For the first time, U.S. CLO managers will have to comply with the new constraint of the Dodd-Frank Act’s risk retention rules. Questions around CLO managers and retention financing strategies have been swirling around for some time, but the proof will finally be in the pudding in 2017.”

Risk retention regulations that require CLO managers to retain a 5% stake in CLOs took effect on Dec. 24, but U.S. president-elect Donald Trump has voiced plans to dismantle Dodd-Frank.

“We enter 2017 assuming risk retention will be in effect, which we believe will lead to lower issuance relative to 2013-2014, and to a more concentrated CLO market,” Wells Fargo analysts said. “We believe that risk retention could make issuance more orderly, and more stable, as issuers should be less dependent on opportunistic or short-term equity investors.”

JPMorgan analysts forecast about $50 billion to $60 billion of U.S. supply, excluding refinancings, and about €20 billion of European volume.

“With Brexit still fresh in our memory, we had already planned on change as our leitmotif when a Trump-sized wrench was thrown into the outlook,” the JPMorgan analysts wrote. “As markets start dancing to the tune of reflation and EM to DM rotation, floating-rate CLOs will be a good place to be in. Look for primary U.S. CLO AAA spreads to tighten by 20 [basis points] to L+135 [bps] by end-2017 on the back of lower supply, rising rates, and less competing refi/reset activity.”

2016 deal volume

U.S. broadly syndicated CLO volume for 2016 totaled more than $62.6 billion, down from the $91.39 billion brought to market in 2015, according to BofA Merrill Lynch.

In addition, more than $35.7 billion of U.S. CLOs were refinanced or reset in 2016, much higher than the $10.46 billion of CLOs refinanced in 2015.

Middle-market deal volume for the year came in at about $7.7 billion, slightly higher than the $6.4 billion placed in 2015.

“The U.S. CLO primary market had a challenging first quarter also due to high market volatility,” the BofA Merrill Lynch analysts said. “Only two deals priced in January and a total of $7.6 [billion] in Q1. We revised down our issuance forecast for 2016 from $70 [billion] to $45 [billion] following this pick up in volatility. As conditions ameliorated, primary activities started to pick up in Q2 and remained robust in Q3 despite the surprising Brexit result. In light of the pick-up in loan supply, recovering market stability and the re-opening of the primary market in Q2, we revised our issuance forecast back up to $60 [billion].”

CLO deal sizes also were smaller in 2016, compared to the $1 billion transactions brought in 2014 and 2015.

“Transaction sizes were on average 12%-14% smaller to $456 [million] in 2016 versus 2014 or 2015 and in fact almost identical to the $457 [million] average in 2012, which issued $55.71 [billion],” according to the JPMorgan analysts in their report. “We also noticed that the number of upsizes dropped in 2016 relative to prior years. Going forward, we think it’s reasonable to assume that transactions could be smaller, based on more onerous capital constraints and a willingness to diversify risk retention held assets in favor of smaller, potentially more frequent offerings.”

In the European primary market, about €16.5 billion of CLOs priced in 2016, compared to the €13.55 billion sold in 2015.

Year-to-date European CLO supply is the highest deal volume since 2007, according to the JPMorgan report.

“This is still below the pre-crisis peak (€42 billion in 2006), but a step in the right direction,” the analysts said. “Along with broader European credit, CLOs have been helped by the ECB’s CSPP and monetary policy. While not our base case, if the ECB were to taper its purchase of corporate bonds, if not in March, then potentially in September 2017, this could emerge as a risk.”

Refinancings strong

“U.S. CLO refinancings/resets were a major theme in 16H2 with a record-breaking $25.86 [billion] YTD, but we think this trend will ease in 2017,” JPMorgan said in a November report. “Resets came into vogue as a way of terming out preexisting structures with a built-in investor base, without the asset sourcing constraints of a new issue. While the reset wave makes sense for both investors and issuers, we think activity will decline from 2017 as the incentive for the issuer diminishes with risk retention.”

In 2016, the first European CLO refinancing occurred in September with at least five more euro-denominated deals refinanced by early December.

Carlyle Group LP affiliate CELF Advisors LLP was the first CLO manager to refinance a European CLO. The €268.7 million CGMS Euro CLO 2013-2R was refinanced on Sept. 30 with a new AAA coupon of Libor plus 115 bps, 20 bps tighter than the old AAA coupon.

“Going forward we expect European CLO refi issuance to increase from 2016 levels given refinancing/repricing activity in the European leveraged loan market and tight liability spreads,” the JPMorgan analysts said.

In December, KKR Credit Advisors (Ireland) Unlimited Co. was the latest European CLO manager to refinance a deal. The CLO manager refinanced €276.5 million of notes in the Avoca CLO X DAC transaction, reducing the AAA coupon to Libor plus 91 bps from the original Libor plus 140 bps coupon.

Active managers drop

Since the finalization of the risk retention rules in 2014 when U.S. CLO issuance hit a record of about $124 billion, the number of active U.S. managers in the primary market has trended down, BofA Merrill Lynch analysts note.

In 2016, 67 CLO managers were active in the U.S. primary market, compared to 87 in 2015 and 106 in 2014.

“We attribute this drop primarily to the implementation date of U.S. risk retention rules (Dec. 24, 2016),” BofA Merrill Lynch analysts said. “Although deals priced before Dec. 24, 2014 would be ‘grandfathered,’ dedicated CLO managers began looking for solutions as early as 2015. Equity investors are therefore less inclined to invest in a manager who might not be sufficiently capitalized for them to exercise their refi option after Dec. 24, 2016.”

During 2016, the most active CLO issuers were Carlyle and GSO/Blackstone Debt Funds Management LLC, which each issued four CLOs.

In addition, four CLO managers, including Newfleet Asset Management, LLC, Teachers Advisors Inc., Guardian Life Insurance Co. of America subsidiary Park Avenue Institutional Advisers LLC and AB Private Credit Investors LLC priced their first CLO deals in 2016.

Spreads grind tighter

CLO spreads slowly improved over 2016.

“The roller coaster ride of CLO spreads in the first half of the year turned into what became basically a long grind tighter in the second half of the year,” JPMorgan said in a report. “Though there has been some widening in recent weeks based, at least partially, on a deluge of supply, all together, secondary 3.0 CLO spreads are anywhere from 25 bps to 90 bps tighter with outperformance in the belly of the credit curve.”

Compared to November 2015, U.S. CLO spreads are 33 bps, 40 bps, 50 bps, 25 bps and 25 bps tighter from triple-A to double-B tranches and 75 bps wider for single-Bs at Libor plus 135 bps, Libor plus 195 bps, Libor plus 285 bps, Libor plus 475 bps, Libor plus 800 bps and Libor plus 1,125 bps, respectively, BofA Merrill Lynch reports.

In 2017, new issue U.S. CLO AAA spreads are forecast to tighten modestly and reach a mid-point of Libor plus 145 bps by the middle of the year and Libor plus 135 bps by the end of the year, from the current mid-point area of Libor plus 154 bps, according to JPMorgan.

“Demand should remain strong both domestically and internationally even after spreads tightened 6 bps in 2016, and 14 bps from wides in February,” the analysts said. “It’s possible that to the extent CLO AAAs tighten past our forecast; we could see real money investors begin to dip further down the capital structure.”

“Most investors expect U.S. CLO aggregate spreads to tighten in three and six months.” – BofA Merrill Lynch analysts in a forecast report

“Going forward we expect European CLO refi issuance to increase from 2016 levels given refinancing/repricing activity in the European leveraged loan market and tight liability spreads.” – JPMorgan analysts in a note

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