A Red-Hot Corner of Wall Street Catapults Toward $1 Trillion Mark

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Wall Street is packaging leveraged loans into bonds at a record pace, stretching bankers, lawyers and debt graders to the limit while showing no signs of slowing.

Money managers that bundle and sell collateralized loan obligations are finding they have to make reservations with bond-rating firms months in advance to get a deal graded. Lawyers say they’re pulling all-nighters to keep up with the flood of documents needed to offer the securities to investors. And firms that arrange or buy the deals are trying to bolster their thinly-stretched staffs, creating a bidding war for talent amid an already limited pool of specialists.

Fund managers have sold more than $200 billion of U.S. CLOs this year, including refinancings and resets, a breakneck pace that’s catapulting the market toward $1 trillion globally. It could get even more frenetic soon. Private equity firms are inking bigger and bigger buyout deals, which are typically funded by the loans that get stuffed into CLOs. Collateralized loan obligations issued over the past two years are also increasingly becoming eligible for resets and refinancing.

A Red-Hot Corner of Wall Street Catapults Toward $1 Trillion Mark

The overwhelming volume in some ways echoes the blistering pace at which banks and ratings firms cranked out collateralized debt obligations linked to mortgages during the housing bubble. A Senate subcommittee report in 2011 found that ratings firms hadn’t hired enough staff or devoted enough resources to ensure that the grading process generated accurate assessments.

In one now-famous 2007 instant message included in that report, an S&P Global Ratings analyst said that their firm graded every deal, adding, “it could be structured by cows and we would rate it.”

This time around investors say there’s little evidence that the deluge of work is resulting in any deterioration in the quality of deals coming out, at least so far. Instead it’s just complicating the process of putting CLOs together, and possibly slowing the pace of sales.

“There is a bottleneck. Think of CLOs as an assembly line, that goes from hand to hand. When there is a holdup in one part of the assembly, the whole system backs up,” said Wayne Hosang, a portfolio manager at Crescent Capital Group. “There could be more deals were it not for the bottleneck.”

Inflation Protection

The biggest bottleneck is at ratings firms. S&P, the bond grader that had grabbed the largest market share for rating CLOs, is where the backup is most acute, with ratings slots for June, July and August already filled, according to money managers that put together CLOs.

The firm has more ratings volume now than it did in 2017 and 2018, periods of record activity, according to an analysis in May by Nomura. In more normal times, asset managers that want grades for their securities can submit their deals almost immediately instead of waiting months.

Fitch Ratings, which often looks at deals that either Moody’s Investors Service or S&P are also rating, faces a similar though far less severe bottleneck, according to market watchers. CLO managers are being forced to plan well in advance, with some scheduling deals well into next year.

“Everybody is now in line, queuing their deals for the rest of the year,” said Olga Chernova, chief investment officer at Sancus Capital Management. “It’s not so easy for ratings agencies to get more staff. There’s a limited pool of qualified candidates. It takes time to train people. It’s a complex product.”

S&P declined to comment for this story. But in a note it released earlier this month it said “we are taking steps to manage the increase in demand and are working to expand our resourcing accordingly.” The firm added that it is addressing “hiring and training needs” and will only accept new grading engagements if it has the “resources and capacity necessary to provide the highest quality ratings.”

Fitch’s Derek Miller, head of U.S. structured credit, said in an emailed statement, “We are appropriately staffed and resourced and continue to provide the market with thorough and timely commentary.”

Moody’s, which had been losing market share, seems to be winning more business now because it has more capacity to rate transactions, said Tom Shandell, chief executive officer of Marble Point Credit Management, which puts together CLOs.

Jian Hu, a managing director at Moody’s, said “We have responded, and will continue to respond, to transactions where we have been mandated in a timely manner, applying our rigorous methodology.”

Investors are clamoring for CLOs because they carry ratings as high as AAA and typically pay more than government bonds or other alternatives that have yielded next to nothing amid an unprecedented era of low rates. CLOs also pay floating rates, offering protection against resurgent inflation.

While the bonds are linked to loans to companies that are often rated junk, they’re structured to offer a cushion against defaults, an attractive feature amid an uneven economic recovery.

That demand is flowing through to the so-called leveraged loan market, as the money managers that assemble CLOs scramble to get their hands on debt sold by junk-rated companies. That’s making it easier for speculative-grade corporations to borrow, and for private equity firms to pull off leveraged buyouts.

‘Burning Out’

Lawyers that write prospectuses and other documentation for CLOs say they’re working all hours and even pulling all nighters to keep up with the business. J. Paul Forrester, a partner at Mayer Brown in Chicago, said his CLO group has pulled in some colleagues from teams that cover areas like commercial mortgage bonds, but there are enough nuances to CLOs that you can only repurpose a few people from other areas.

“We worry that people are burning out. It’s gotten to the point that we are afraid that people will run out of the building screaming,” Forrester said. “There’s only so many hours in the day.”

With so much deal flow, buyside firms have been hiring more bankers than usual. Theo Fleishman went from CLO arranger Natixis SA to buyside firm Nearwater. Oswald Espinoza moved from JPMorgan Chase & Co. to KKR & Co. Cyrus Moshiri switched from Goldman Sachs Group Inc. to New Mountain Capital.

“There has been an unnatural amount of turnover at the CLO desks on the sellside,” said Don Young, co-founder of CBAM, an asset manager that builds and sells CLOs. “People are being bid away by both the buyside as well as other banks.”

More Coming

Over the next few months, most pandemic-era deals will end what’s known as their “non-call period,” when refinancing and resets are restricted. Because many were sold when risk premiums were unusually high, market watchers expect a large number of them to be refinanced or reset. About 80% of these Covid-era deals ending their non-call period were rated by S&P only, or S&P and Fitch, according to Nomura.

And before the pandemic, most transactions had two year non-call periods, so deals minted in 2019 can be refinanced or reset as well, meaning there could be more deals that can be reworked than usual.

Nomura estimates about $140 billion of deals were in the money for a refi or reset in May, and for that amount to increase to $180 billion by year-end as more deals roll off their non-call period. In mid-January, just $111 billion of securities were eligible for refinancing or resetting.

New Deals

On top that, new CLO creation is going strong. Investors in search of higher yielding assets are eager to buy the equity portions of the deals, which offer the highest potential payments and are the first to take losses when companies default. Once those portions of deals are placed, it’s often relatively easy for bankers to offload the less risky parts.

All this is unlikely to stop anytime soon, according to Rob Zable, senior portfolio manager of U.S. CLOs and closed-end funds at Blackstone Credit.

“The fundamental picture continues to rapidly improve, which we anticipate will accelerate further in the second quarter,” Zable said. “Refi, reset and new issue volumes have been elevated and we expect this to continue given strong performance and investor interest.”

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