The Catch 22 about CLOs

A few weeks ago, I noted it was sellers market in credit. Since then, the market has had some very heavy days and some rather strong days. A few deals have even been pulled from the market on the bond side. With that said, the primary market was hefty to say the least, settling a monthly record with over $47.5B of paper being priced according to JPM. Winners in the month were trading names typical of this stage of the cycle with names like Petroplus, Ambac, Affinion, and Geokinetics seeing large price moves higher.

Leveraged loans also delivered a strong month. And frankly, the technicals felts a lot stronger than the high yield market. According to JPM, $34B loans priced during th emonth making it the 12th most active month ever. For the year, the CSFB Leveraged Loan index is up 7.80% with JPM reporting leveraged loans have gained 8.66% year to date.  All in all it was a very strong month (and so far year) for leveraged finance.

One vehicle that also shined this month were CLOs. 13 new CLOs priced in September with a total value of $6.2B. On a year to date basis, $32B of CLOs have priced which is nearly 3x as much as last year. This is still a far cry from the nearly $90B that priced in 2007. Just today LCD reported yet another CLO being priced by Och-Ziff with AAA garnering a L+148 coupon. I am hearing the forward pipeline is very strong with underwriters and arranging banks pushing the product hard on asset managers. Less reported, but still widely important: Secondary CLO spreads tightened up and down the capital structure.

I often talk about uneconomic sellers being the path to riches in investing. Find someone that HAS to sell, provide that seller with liquidity at a steep discount, profit. Capitalizing on problem or issue that has no impact (or very little impact) on the intrinsic value of securities is a profitable endeavor. The opposite is also true: Buying as asset or asset class because you have can be a terrible UNPROFITABLE endeavor. If a high yield manager is doused with inflows, he or she may have to put that capital work into a well-bid market where all of their peers have the same problem: Too much capital, not enough liquidity/sellers, buying assets higher.

When you think about the data I listed above of $6.2B of new CLOs vs $34B of primary loan issuance you wouldn't think there would be a problem. But then you start ticking off other salient factors:

• According to JPM, $9B of paper was paid down during the month (amort, bond for loan issuance)
• Refinancings accounted for nearly 50% of volumes in September
• There was an additional ~$1B capital coming into the asset class via retail inflows and possibly more from non-bank / non-CLO participants

So, with that said loan managers had to put $9B of paper to worth  (because it was paid down), and 50% of the volume was simply refinancing. So - realistically there was about $17B of new paper, up for grab for loan managers. $6.2B + $1B of new capital + $9B of pay downs gets you pretty close to that number. Now this is a simple exercise that doesn't take into account CLO managers that are past their reinvestment window and are unable to deploy new capital into loans except via amend and extends (which isn't really new money capital - but its a way to stay in the game and collect manager fees).

I have used the term in the past, but I think "feeding the beast" is an appropriate analogy for CLO structures. CLOs, due to their leverage, have liabilities to pay. To pay these liabilities, CLOs investing in underlying loans of corporations and capture an arbitrage spread. Assuming a few defaults here and there with modest recoveries, everyone, including the equity holders should be happy with their performance. But what if there weren't any underlying loans to buy?

CLOs need underlying loans to survive. In their ramp up, "warehousing" period, loan managers buy up loans to start the arbitrage machine in motion. When the market is really hot, managers are crawling over one another to try to get the best allocation to work for them as efficiently as possible. When the market is really slow and not a lot of private equity or M&A activity is happening to fuel issuance, again CLO managers are fighting to get allocations or bidding up existing paper to feed the beast. 

I worry the next cycle for leveraged loans will be a lot more painful than 2008. I worry a scenario where CLOs outside their reinvestment period are unable to purchase loans and there is simply just too much supply of loans to go around and prices have to clear at a level to get non traditional buyers into the market. This creates a vicious cycle where performing CLO tests will begin to fail (OC cushion) and they too will be less likely to purchase loans at a discount. And since TRS are not what they used to be, hedge funds may have to wait until loans get even lower because a L+500 asset at 80 doesn't quite hit the hurdle rate at 3x leverage (maybe 5x). Given the changes regulation like Dodd Frank has graced us with, dealer inventories are light and markets will be very very wide. And finally, many investors got a free pass (temporarily painful one) in the last cycle the matra of CLO AAA being an unbreakable structure is becoming accepted as religion is downright frightening.

The way I see it: Only an uneconomic buyer would buy a dividend deal with no covenants at these spread levels.