CLOs rebounded in the first quarter as credit concerns receded. Lower interest rates may drive continued interest in the asset class moving forward.
Slow Start: 2019 experienced a slow start for new CLO issuance. It took investors several weeks to get comfortable with the drivers behind the spread widening that occurred in the fourth quarter of 2018. Spreads of CLOs trading in the secondary market began to tighten during the first week of January, as the recent volatility was deemed to be technical in nature, and credit concerns took a backseat. However, the first new deal pricing didn’t take place until late January, and there were only 10 U.S. deals priced in total for the first month. Issuance activity eventually normalized in February and March and, as a result, first quarter totals were $29.28 billion for new U.S. CLOs and €6.89 billion for EUR CLOs.1
Term Curve: There have been an increased number of new and reset CLOs coming to market with shorter reinvestment periods. Most CLOs issued after 2015 have had a reinvestment period of five years, with a non-call period of two years. However, so far in 2019, there have been eight CLOs with reinvestment periods of two years or less, and shorter non-call periods according to LCD News. We see this as a result of less demand for the AAA tranche. If a manager’s AAA tranche cannot price at a tight enough spread as a 5-year deal, the manager will consider issuing their deal with a shorter reinvestment period in order to achieve a lower spread on their AAA tranche, and therefore lower their overall funding cost to a more economic level.2
Regulations: Late in the first quarter, the Japanese Financial Services Agency (JFSA) clarified that an increased capital charge will not be applicable to non-risk retention compliant securitized assets, on the condition that the investor can determine the assets “were not inadequately formed” and were “originated appropriately.” As CLO collateral pools consist of broadly syndicated loans with ratings from multiple ratings agencies, CLOs should not be subject to the additional capital charge for Japanese investors. This ruling is a positive one for U.S. CLO managers who continue to rely on Japanese banks to invest in their AAA tranches. According to a recent Wells Fargo report, Japanese banks own 20-25% of both U.S. and European outstanding AAA tranches.3
CLOIE Index 2019 YTD Returns1
- Uncertain is the word that best describes the current outlook for the CLO market. Given the rapid decrease in interest rates and resulting yield curve inversion that occurred toward the end of the first quarter, it will be interesting to see the direction of our market trends going forward. So far this year, U.S. CLO spreads are range bound—with new AAAs pricing within a wide range of 135-150 bps, 3-month LIBOR interest rates falling from 2.8% to 2.6%, and U.S. Treasury 10-year yields falling from 2.6% to 2.4%. Many market participants began the year predicting CLO spreads would be flat to wider over the course of 2019—but with rates starting to trend lower, the attractive yields CLOs offer could be a catalyst for demand to increase, and also drive spreads tighter over the course of the year.
We recently discussed our market views in more detail, which are available in both podcast format and written Q&A format.
1. Source: J.P. Morgan. As of March 31, 2019.
2. Source: LCD News. As of March 31, 2019.
3. Wells Fargo. CLO Lagniappe: Ides of March Update. Published March 15, 2019.