Deal flow remained steady in Q3, keeping primary market spreads range-bound. Against a backdrop of low global interest rates, we have seen increasing investor interest in European CLOs.
Steady New Issuance in Primary Markets
The issuance of new CLOs has remain steady throughout the year. However, August was the only month of the third quarter that experienced a reduction in new issuance over the previous year. Only 16 CLOs totaling $7.1 billion, were issued in the U.S. and no new European CLOs were priced in August. Throughout the rest of the quarter, steady deal flow kept primary market spreads range-bound mirroring the trend seen thus far in 2019.
The secondary market became more bifurcated as the quarter progressed, and market participants made a bid for top-tier manager deals backed by strong collateral pools. It is worth noting that we witnessed a large dispersion of CLO spreads at the BB tranche level in the secondary market. Bonds from well-known managers with attractive credit profiles have traded with a discount margin (DM) ranging from the high 600s to low 700s, while bonds from lesser-known managers with credit profiles showing signs of weakness have traded with a DM in the mid-700s to low 800s.
Shorter-Lived Deals in High Demand
The CLO market has seen an increase in demand for deals with a shorter (i.e. 1–2 year) reinvestment period, versus the traditional 5-year reinvestment period included in newly issued CLOs. Many managers are willing to fulfill this demand, since it likely means that their AAA debt will price at a tighter spread than the AAA debt of a traditional 5-year. This lower pricing is beneficial to a CLO manager, as well as the CLO’s equity tranche holders, since it lowers the structure’s overall cost of debt—thereby creating excess spread that equates to higher equity returns. New 5-year AAA CLOs are being issued at spreads of 130–135 basis points (bps), while the shorter profile AAAs are pricing with a DM of 112–125 bps.
AAA U.S. CLO Primary Market Curve:
Effect of Deal Lifespan on Pricing
SOURCE: LCD. Red data points represent third quarter deal pricings. As of August 31, 2019.
European CLOs Look Attractive
As macroeconomic headwinds continue to pressure markets, investors are attempting to find a port where they can weather the anticipated storm—although finding one with attractive yields is proving difficult. With some global interest rates now in negative territory, investors are increasingly attracted to European CLOs that have a built-in structural feature that protects against negative rates, in the form of a 0.0% EURIBOR floor. As EURIBOR has trended further negative, the Euro CLO coupon payments have remained unchanged, providing steady yield—while comparable asset classes with no reference rate floors have continued to fall. The higher demand for steady yields has resulted in tightening new issue spreads for Euro CLO senior tranches. We are likely to see an increase in refinancings and/or resets in the European CLO market as a result of the tighter spread environment.
- We expect new issue CLO spreads, up and down the capital structure, to remain relatively range-bound through year-end. While investors continue to focus on both macroeconomic risks—including global growth and trade tensions with China—and idiosyncratic risks in portfolios, the all-in yields for CLO debt tranches remain attractive relative to other asset classes.
- In our view, a muted new issuance calendar, as a result of a challenging environment for CLO equity arbitrage, should be supportive of spreads.
- Given investors’ bias toward new issue CLOs with less risk in the underlying credit portfolios, we could see some continued weakness in seasoned mezzanine tranches with larger exposures to more recently storied credits.