CLO Machine Is Approaching Full-Tilt, Eroding Credit Quality

(Bloomberg) -- Wall Street’s hottest debt market is approaching hyperdrive.

Investors haven’t been able to get enough of the repackaged corporate loans known as collateralized loan obligations. That intense demand, is allowing the managers that put these securities together to sell off pieces of CLOs that by law they previously had to hang on to. These sales are the crest of what could be a $7 billion wave of such deals.

The frenzied buying isn’t limited to older securities -- Wells Fargo & Co. is forecasting that there will be a record $150 billion of new U.S. CLOs issued this year. Moody’s Investors Service, the biggest bond grader for CLOs, can’t keep up with the demand for its services, and is taking around a month more to rate the securities than it needed before.

That strong demand is allowing managers to sell CLOs with weaker protections, and it’s making the leveraged loans that get bundled into the securities riskier too. Investors are buying CLOs because they are floating rate: they offer protection against rising interest rates and against losses if loans default. The securities performed relatively well during last decade’s financial crisis. But risks are building for CLOs now, investors said.

“Demand from the CLO machine for loans has helped companies get the most attractive financing,” said Michael Temple, Amundi Pioneer’s director of U.S. credit research. “But it also means a lot of CLOs have been stuffed with weaker credits. A downturn, if and when that happens, will uncover these weaknesses.”

CLO Machine Is Approaching Full-Tilt, Eroding Credit Quality

The latest round of CLO selling is coming from managers that put together the securities and held onto a portion of them, to comply with rules known as “risk retention.” The regulations were designed to prevent a repeat of the subprime crisis, where lenders made bad loans and sold them off to investors that were stuck with the losses when the debt soured.

In February, an appeals court decided that risk retention rules don’t apply to CLOs. That decision has freed up the firms that put CLOs together to sell the securities they had retained, which are typically five percent of a transaction that was put together after the rule went into effect for CLOs in December 2016.

Neuberger Berman, Seix Investment Advisors, BlueMountain Capital Management and Credit Suisse Asset Management have sold almost $800 million of bonds they had retained. People who participated in the auctions said they had trouble getting the securities they wanted, and that most were bought by banks who are expected to sell many of them to investors.

New Entrants

Bank of America Corp. estimates that there are around $7 billion of retained CLOs known as vertical strips that could potentially be sold in total. The market can absorb that kind of supply over time, strategists led by Chris Flanagan wrote, because there’s weekly trading volume of about $1.4 billion plus issuance and refinancings of around $5 billion.

The end of risk retention is making it cheaper and easier for managers to put together CLOs, and more have entered the business as a result. CarVal Management, Kayne Anderson Capital Advisors, and Partners Group all offered their first CLOs this month. In the first quarter, $37 billion of the securities were issued in total, a 118 percent increase from the same period last year, according to data compiled by Bloomberg.

Middle-market CLOs have seen a "boom in volume" and the lower asset quality of such deals is concerning, Angel Oak Capital Advisors senior CLO portfolio manager Berkin Kologlu said. He’s stopped investing in them, he said.

“There has been a seismic shift in the rules of the market with the repeal of risk retention,” said Laila Kollmorgen, a managing director at PineBridge Investments LLC. “We believe it’s a game changer.” But if supply of CLOs rises too much, it may grow less profitable for managers to buy loans and bundle them into bonds, which may in turn weigh on supply, she added.

One negative for building the securities is that there are fewer loans being made to companies with junk ratings that can be bundled into new bonds. Sales of leveraged loans declined to $239.3 billion in the first quarter compared with $348.3 billion for the same period last year, according to data compiled by Bloomberg.

Standards Eroding

With more money from CLOs chasing fewer loans, lending standards are showing signs of eroding. The proportion of loans classed as “covenant lite,” where the lending covenants provide fewer protections for investors, rose to 77 percent in 2017 from 23 percent in 2012, while the extra reward investors get for owning the debt declined, Moody’s said in a report published Wednesday.

Some money managers believe CLO issuance this year will fall short of the bullish forecasts from banks like Wells Fargo. Tom Majewski, managing partner and founder of Eagle Point Credit Management, forecast $90 billion to $110 billion of sales for 2018 at a conference this week.

Although potential risks are rising, analysts see few reasons to panic now. The default rate for leveraged loans continues to fall, according to Moody’s, which forecasts their declining further to 1.6 percent in March 2019 from 3.9 percent in March of this year. CLO securities also have higher levels of subordination -- or cushion against losses-- than they did during the financial crisis, during which they performed well, according to Jian Hu, a managing director who rates CLOs at Moody’s.

But at some point, the economy and credit markets will shift, and whenever that happens, losses from loans will likely be higher than they’ve been historically, according to Hu. Covenants are generally weaker, and more borrowers have loans as their only form of debt, which can force creditors can take more losses. When the credit cycle does turn, investors used to recovering around 77 cents on the dollar from first-lien loans to failed companies may find themselves with closer to 60 cents, Moody’s Investors Service forecast in March.

“We need to have a risk management approach in how we think about the CLO market now,” Gene Tannuzzo, a money manager at Columbia Threadneedle Investments, said. “It feels a lot like 2006; you’re hearing of new, smaller entrants and we should be prepared to see riskier issuers. This market is no longer a secret.”

©2018 Bloomberg L.P.