Download Key Issues in the CLO Market Today

Key Issues in the CLO Market Today
Moderator:
Meredith Coffey, LSTA
Panelists:
Suraj Bhatia, Sumitomo Mitsui
Wynne Comer, BAML
Paul Hatfield, Alcentra
Asif Khan, Mitsubishi UFJ
Rachel Russell, Morgan Stanley
Topics

State of the CLO market today

How CLOs are responding to the changing regulatory environment

Outlook for the asset class
State of the CLO Market Today
CLOs Have Been A Success Story
CLOs saw strong 20-year performance
US CLO issuance recovers
120
100
80
US CLOs outstanding continue to grow
350
2009-2013
300
<=2008
250
200
150
100


Source: Moody’s, Thomson Reuters LPC Collateral
Apr-15
Jan-15
Oct-14
Jul-14
Apr-14
Jan-14
Oct-13
CLOs performed very well during (and after) the Financial Crisis
U.S. CLO issuance and outstandings have grown
And this is a good thing! CLOs provide long-term financing to U.S. companies and stabilize the
secondary loan market
Jul-13

Apr-13
0
Jan-13
50
Oct-12
2014
2013
2012
2011
2010
2009
2008
0
2007
20
>=2014
400
Jul-12
40
CLOs outstanding ($Bils.)
450
60
2006
Impaired
1.1%
2005
Unimpaired
98.9%
US CLO issuance ($Bils.)
140
CLO Asset Quality is Strong
US CLO energy exposure is low
US and European CLO CCC holdings decline
14%
Energy
Industrials
12%
Materials
4%
Technology
S&P LSTA LLI
US CLO 2.0
CDX HY (HY24)



HY Cash
CLO assets are strong
Defaulted and CCC holdings are low
Energy exposure is low
Source: Bank of America Merrill Lynch, Morgan Stanley
Dec-14
25%
Jul-14
20%
Feb-14
15%
Sep-13
10%
Apr-13
5%
Nov-12
0%
Dec-09
Transportation
Jul-09
0%
Feb-09
Consumer Staples
Jun-12
US CLOs
European CLOs
2%
Utilities
Jan-12
Healthcare
6%
Aug-11
Media
8%
Mar-11
Consumer Disc
Oct-10
Telecom
10%
May-10
CCC holdings (%)
Financial
CLO Spreads vs. Other Asset Classes
AAA Relative Value
160
140
Spread (bps)
120
100
80
60
40

US CLO 2.0
Euro CLO 2.0
SFR
Euro CLO 1.0
Private SLABS
US CLO 1.0
IG Corp
CMBS 3.0
Subprime Auto
FFELP
Credit Card
UK RMBS
FNMA CC
0
Prime Auto
20
Despite strong performance and quality collateral, CLO spreads remain wide relative to other asset
classes
Source: Bank of America Merrill Lynch
CLO Liability Spreads are Narrowing
US CLO spread ranges vs. end of April levels
US CLO issuance and AAA spreads
16
Issuance
Avg AAA spread*
12
10
spread in bps
170
160
145
US New Issue AAA
145
US New Issue AA
200
US New Issue A
290
US New Issue BBB
400
150
8
140
6
130
4
120
2
110
0
100
Jan-12
Mar-12
May-12
Jul-12
Sep-12
Nov-12
Jan-13
Mar-13
May-13
Jul-13
Sep-13
Nov-13
Jan-14
Mar-14
May-14
Jul-14
Sep-14
Nov-14
Jan-15
Mar-15
Thru 15 May
US CLO issuance ($Bils)
14
180


160
200
260
300
360
410
475
650
US New Issue BB
610
CLO issuance was strong through April 2015
While strong issuance has supported AAA spreads, CLO liability spreads have narrowed recently
*Excludes MM CLOs
Source: Bank of America Merrill Lynch, Morgan Stanley
700
US CLO Asset-Liability Spread Narrows in Early 2015
CLO liability spreads vs. loan spreads
650
600
550
Spread (bps)
500
450
400
Loan Spreads All Loans (STM)
350
WA CLO Liability Spread
300
250
200
150
Jan-12
Jul-12

Jan-13
Jul-13
Jan-14
Jul-14
Jan-15
As US loan spreads tightened in early 2015, the asset-liability spread narrowed
Source: Bank of America Merrill Lynch
0
12/31/2009
3/31/2010
6/30/2010
9/30/2010
12/31/2010
3/31/2011
6/30/2011
9/30/2011
12/31/2011
3/31/2012
6/30/2012
9/30/2012
12/31/2012
3/31/2013
6/30/2013
9/30/2013
12/31/2013
3/31/2014
6/30/2014
9/30/2014
12/31/2014
3/31/2015


Source: S&P Capital IQ/LCD
0%
0
Loan spreads/yields will see additional pressure from repricings
Value of LIBOR floors may erode as interest rates rise
4/1/2015
3/1/2015
2/1/2015
1/1/2015
12/1/2014
11/1/2014
50
20%
10/1/2014
40%
9/1/2014
150
8/1/2014
100
60%
7/1/2014
Floor level
6/1/2014
200
80%
5/1/2014
Percent with floors
4/1/2014
100%
3/1/2014
Almost all loans have LIBOR floors (which are shrinking)
2/1/2014
250
Repricing volume ($Bils.)
300
1/1/2014
LIBOR floor (bps)
Loan Spreads/Yields Under Continued Pressure
Loan repricing activity returns in April 2015
40
35
30
25
20
15
10
5
US CLO Redemptions and Refinancings Accelerate
Monthly US CLO Refinancing Volume
120
3.0
100
2.5
US CLO refi activity ($Bils.)
80
60
40
1.5
1.0

As loan yields narrow, arbitrage may be further reduced
In turn, there could be more repricing or refinancing activity
Source: S&P U.S. Structured Credit, S&P Capital IQ/LCD
Apr-15
Mar-15
Jan-15
Dec-14
Nov-14
Oct-14
Sep-14
1Q2015
Aug-14
2014
Jul-14
2013
Jun-14
2012
Thru 15 May

2011
May-14
2010
Apr-14
2009
Mar-14
-
Feb-14
0.5
20
0
2.0
Jan-14
Count of CLOs redeemed
Annual Count of CLOs Redeemed
How CLOs are Responding to the
Changing Regulatory Environment
The Volcker Rule: The Issues





Banks are generally not permitted to “own” CLOs if the CLO has
any non-loan investments
Ownership applies to investment in CLO AAA or AA tranches if
notes have ability to remove/replace CLO manager; other indicia
of “ownership” may apply
There is no grandfathering
Almost all CLOs issued prior to the rule coming out (December
2013) originally had baskets for non-loan investments, and over
half had at least one non-loan investment (like a HY bond)
Banks were required to amend or divest non-compliant CLOs by
mid-2015; however, the Fed extended the conformance period to
mid-2017 for CLO notes owned by banks as of YE 2013
Approaches to Dealing with Volcker Rule



Clear solutions

SOTUS (Solely Outside the United States) Exemption

“Volckerizing” amendments

Sale of Notes
Less clear solutions

Waiving Removal Rights

Seeking Forgiveness
Penalties? Banks say that they simply must comply
Risk Retention Rules


Final risk retention rules require CLO managers (or a majority-owned
affiliate thereof) to retain 5% of the CLO’s notes
Forms of retention








Vertical pro rata retention – 5% of the face value of each of the CLO notes
Horizontal residual retention – equity in the amount of 5% of the fair value of CLO notes
“L-shaped” retention – a combination of vertical and horizontal retention
For a $500 million CLO, this would be $25 million, regardless of the form
of retention
Goes “live” on Dec. 24, 2016 (but managers are determining their
compliance strategy now)
Market is developing approaches like Capitalized Manager Vehicles or
Majority Owned Affiliates
Term financing may be available
There are points of clarification that will be necessary
Risk Retention & Refinancings: US CLO Non-call and
Reinvestment Periods Shorten, then Lengthen in 2015
Non-calls, reinvestment periods adapt to changing markets
Non-Call, Reinvestment period (yrs)
6
5
Non call
Reinvestment
4
3
2
1
0
11/22/2013
3/2/2014
6/10/2014
9/18/2014
12/27/2014
4/6/2015
7/15/2015
CLO issuance date



In 2014, most non-call periods were two years and most reinvestment periods were four years
In 2015, uncertainty around the status of refinancings created diverse non-call periods
Recently, some non-call and reinvestment periods have become longer
Source: S&P Capital IQ/LCD
Refinancings: An Example of Needed
Clarification

The SEC has indicated that CLOs issued prior to December
24, 2014 may be refinanced after December 24, 2016 without
requiring risk retention as long as the only thing that changes is
the coupon on the refinanced note. (For example, a CLO
cannot be Volckerized during this refinancing.)

CLOs issued after December 24, 2014 will be subject to risk
retention if the notes are refinanced after December 24, 2016.

CLO manager would likely only need to purchase and retain
5% of the new notes that are issued in conjunction with the
refinancing, not 5% of the full CLO capital structure.
What the 2.0 Manager Universe Looks Like Today
2.0 CLO AUM by manager type
40
Bank, $19bn,
7%
35
15
10


CLOs are managed by a diverse set of asset managers
A number of CLO managers have less than $1 billion of 2.0 CLO AUM (though they may have AUM in
other forms)
Source: BofA Merrill Lynch Global Research, Intex, Fitch
>$10bn
$8-9bn
$7-8bn
$9-10bn
AUM
$6-7bn
$5-6bn
0
$4-5bn
5
$3-4bn
Alternative,
$140bn, 47%
20
$2-3bn
Diversified,
$57bn, 19%
25
$1-2bn
Boutique,
$32bn, 11%
30
<=$1bn
BDC, $11bn,
4%
Count of managers
Insurance,
$15bn, 5%
PE, $21bn,
7%
Distribution of CLO 2.0 AUM
Possible Risk Retention Approaches:
Direct Manager Investment
Third Party
Investors
$
CLO Manager
Retention
• Third party investors invest directly
in the CLO manager
• Manager invests in and funds the
required retention amount
Source: BofA Merrill Lynch Global Research, Dechert
Possible Risk Retention Approaches:
Majority Owned Affiliate (MOA)
Third Party
Investors
$
Majority-Owned
Affiliate
(MOA)
CLO Manager
$
Retention
 Manager would continue to be the
collateral manager and receive
management fees while the
retention pieces and associated
cashflow would be held by the MOA
 To qualify as a majority holder, the
manager must control the major
economic decisions of the MOA and
hold a controlling financial interest
as determined under GAAP
Source: BofA Merrill Lynch Global Research, Dechert
Possible Risk Retention Approaches:
Capitalized Manager Vehicle (CMV)
Capitalized
Manager Vehicle
(CMV)
CLO Manager
Retention
Specified
Fee
$
Staffing &
Credit
Services
Third Party
Investors
Service Provider
• Involves creating a new CLO
manager which would manage the
CLOs and hold the retention
• Could be capitalized by equity or
debt and equity with 3rd party
investors investing into the CMV
• Has to be self-managed and staff
could be employed by the CMV or
be obtained through a staff and
servicing agreement
• Substantive decision-making power
would have to reside at the CMV
Source: BofA Merrill Lynch Global Research, Dechert
What are Managers’ Plans?
How likely are you to issue new U.S. CLOs in the next two years?
(Responses: 52)
Very likely
Quite likely
Somewhat likely
Not likely at all
0
20
40
60
80
100 (%)
How do you plan to meet U.S. risk retention requirements?
(Responses: 52)
Horizontal interests
Vertical interests
L-shaped interests
Eligible horizontal cash
reserve accounts
Varying on a deal-by-dealbasis
0
5
10
15
20
25
30
35
40
Note: Responses do not add to 100% as managers were allowed to indicate all options under consideration.
Source: Fitch Ratings
45
50
55 (%)
What are Managers’ Plans?
What type of entity do you plan to use to achieve U.S. risk retention?
(Responses: 51)
Majority owned affiliate of manager
Existing manager as sponsor
New manager as sponsor (U.S. CLOs only)
New manager as sponsor (U.S. and
European CLOs)
Varying on a deal-by-deal basis
0
5
10
15
20
Note: Responses do not add to 100% as managers were allowed to indicate all options under consideration.
Source: Fitch Ratings
25
30
35
40
45
(%)
Outlook for the Asset Class
Outlook for the CLO Market

Near term




Last year’s US CLO issuance was $124 billion; what will it be in 2015?
US CLO outstandings currently are $400 billion; what will they be at year-end
2015?
CLO AAA spreads are in the high LIB+140s; where will CLO AAA spreads be
at year-end 2015?
Longer-term





Will Risk Retention drive consolidation among US CLO managers?
More than 100 managers issued US CLOs in 2014; how many will issue CLOs in
2017?
Will Risk Retention reduce the number of CLOs that each remaining manager
issues?
Will the US and European Risk Retention Rules be harmonized?
What will the 2018 CLO market look like?