NEW YORK, Dec 17 (Reuters) - Collateralized loan obligation (CLO) new issue volumes in 2015 will retreat to levels set in 2013, which was the third-busiest year on record, but still 30 percent lower than 2014, according to research analysts covering the sector.
In 2013, $82.8 billion of new deals priced. A repeat of 2014 record CLO issuance, which has already surged to over $115 billion, is unlikely due to the looming onset of recently finalized regulation and expected rising rates that could hurt CLO equity returns.
JP Morgan sees new CLO formation in 2015 declining to $70-80 billion, while Morgan Stanley forecasts a $75-85 billion year, in reports published in late November. Wells Fargo presents a more optimistic $90 billion estimate, also in a late November note.
With risk retention rules approved by federal regulators in October, requiring CLO managers to hold back capital equal to 5 percent of a new deal on their books, the costs of running a CLO platform will likely increase. Risk retention rules will go effective two years after they are published in the Federal Register.
The two-year regulatory window is an incentive to print deals this year before managers will need to assess their longer term commitment to CLOs in 2015, as the effective date of the rules draws closer. Over 100 managers have priced structured loan vehicles this year, according to Thomson Reuters LPC, and some managers will likely consider withdrawing from the CLO market. Ninety-three different managers priced CLOs in 2013.
“Given that CLO managers are typically thinly capitalized, it is hard to envision that many small managers will have access to the long-term capital that risk-retention rules would require,” said Richard Hill, CLO analyst at Morgan Stanley, in a 2015 market outlook note. “Unlike the last CLO manager consolidation cycle that followed the financial crisis, we believe this time around the consolidation economics are not as compelling given a combination of smaller post-crisis CLO management fees and shorter reinvestment periods.”
While regulation may narrow down the list of potential CLO issuers eventually, the pace of new CLO launches will depend on deal economics. If returns continue to appear attractive, CLO sponsors will remain interested in structuring new deals.
“Outflows and the risk-off environment in the last quarter are pushing loan prices down and spreads wider, which is good for the arb,” said Mark Okada, chief investment officer at Highland Capital, at a press briefing last week. “Focus on the equity arb and where that is, and that will tell you where we’re going.”
CLO equity returns will be sensitive to the speed and steepness of interest rate moves as the Federal Reserve deliberates on whether to pursue less dovish monetary policy.
“For equity investors, CLO equity distributions may be pressured as short-term rates increase, due to LIBOR floors on the assets,” said David Preston, CLO analyst at Wells Fargo, in a November report.
Libor floors on loan assets in CLO portfolios create extra spread income for CLO equity owners.
The average Libor floor on loans is 0.98 percent, according to Thomson Reuters LPC, while three-month Libor is currently 0.24 percent. If the difference between actual Libor rates and minimum floor narrows, CLO equity returns would fall and potentially lead to less new CLO activity. (Editing By Michelle Sierra and Jon Methven)