Supply Slowdown Points to CLO Performance
At the end of Q1 we were surprised by the solid pace of supply in CLOs, especially considering the challenging arbitrage dynamics facing issuers. Six weeks on, we’re starting to see some changes. April saw six deals all priced in the period before Easter, and while Q1 supply levels were comparable to 2018, total issuance volume of €9.4bn year-to-date now represents a gradual slowdown versus last year, behind which there are multiple factors.
First, primary supply in the loan market has been disappointing, down 23% in Q1 vs. the same period last year (with bond volume down 43%). Easter holidays are over but last week passed without a single deal being launched in the syndicated loan market, according to Debtwire. Although the M&A deal pipeline will start to churn again, this is driven mainly by large cap transactions and CLO managers thrive on a steady flow of mid-sized transactions in order to get the diversification they need. The pace of ramping in new CLO pools has reduced significantly together with the number of warehousing facilities opened so far this year. As a consequence loan spreads have tightened back to levels seen before the softness of Q4 2018.
Despite the slump in supply, CLO spreads in 2019 vintage primary deals haven’t really moved. After a very slow first two weeks we have seen some spread tightening, but AAAs in particular haven’t budged. Japanese investors have been taking the vast majority of AAA supply in recent times, particularly from the tier one managers. We are hearing rumours of the widening of this Japanese bid, which has already started in the US CLO market. The investor base for new CLOs has shrunk with the bottom part of the capital structure populated by fewer investors (most of them US-based), and hedge funds dominating lower mezzanine and equity tranches. We have commented before that 2019 issuance doesn’t look attractive for several reasons, and it looks like some other European investors agree.
The economics for new CLOs are under pressure and we don’t see why a manager would print now given these conditions; this won’t help debut CLO issues that don’t have the support of an investor anchoring the AAAs. Due to current arbitrage levels only three issuers have come to the market with a refi/reset deal in 2019 so far, for a total of just €1.2bn vs. €6.5bn by the same time last year. With around 10 new CLO managers in the pipeline, ramping portfolios has been a challenge and so a slowdown in supply had looked inevitable. We are starting to see that materialise and the secondary market is reaping the benefits as spreads are tightening.
We think lower issuance will be a good thing for the CLO market. In the secondary market spreads have started tightening after materially lagging more mainstream credit products in the first quarter. Appetite remains for short dated paper and tier one managers with clean pools and documentation, though we have also seen increased activity in longer maturity bonds, especially at the bottom of the capital structure, helping move BB and B spreads 10-30bp tighter vs. March levels.
With benign fundamentals and a positive technical picture, we expect CLOs to outperform in the coming months. This might also help rebalance the arbitrage dynamics in primary, leaving the market in a more healthy place.