The U.S. CLO market has set a new issuance record for the third consecutive quarter, as the insatiable investor demand for leveraged loan debt continues at a dizzying rate.
With about a week to spare, third-quarter primary deal volume has surpassed $43.6 billion, topping the previous high mark of $43.4 billion from the second quarter of 2021, according to LCD. That second-quarter total itself had made the formerly unprecedented $39.8 billion level in the first quarter of the year a short-lived record.
Altogether, U.S. CLO issuance stands at $126.8 billion in 2021 through Sept. 23, via 256 new-issue deals from 107 managers, according to LCD, a pace that is all but certain to soon shatter the full-year record of $128.9 billion established in 2018.
Volume is more than double last year's pace ($61.3 billion) when the market was still recovering from the economic shock of the outbreak of COVID-19.
Among the leading issuers are CLO affiliates of The Blackstone Group, issuing ten CLOs at a total volume of $5.46 billion, a deal count nearly matched by Carlyle CLO Management LLC, which issued $4.89 billion across nine deals. Palmer Square Capital Management has priced $4.90 billion across seven deals, most recently a $1 billion static CLO that stands as one of the largest CLOs of 2021.
Factors in the issuance frenzy are numerous. A continued low-rate environment is driving more yield-starved institutional investors into floating-rate CLO debt instruments, fed by the $1.29 trillion loan market. Also, a historically thin trailing 12-month leveraged loan default rate (0.35% as of Sept. 24, a 9.5-year low) mixed with higher levels of liquidity amid private equity sponsors provides added layers of confidence for managers — even amid deteriorating credit metrics within CLOs (S&P Global Ratings reported in September the share of CCC+ loans in CLOs ticked up to 6.3%, from 5.9% the month prior) and the highest-ever volume of institutional loans (more than $400 billion globally) issued from corporates rated between B+ and B- this year.
"While we know periods like these won't last forever, the current environment appears to have some room to run," noted Tom Majewski, founder and CEO of CLO equity investment firm Eagle Point Credit Co. during an August conference call with analysts.
"I think the number one thing that's easy to get lost in the current market environment is that the net arbitrage for CLOs remains pretty attractive," says John Wright, managing director and co-head of North American liquid and structured credit for Bain Capital Credit. "When we look at the loan market today and see only about a quarter of the loans trading above par, that to us does not signal overvaluation of the underlying loan asset class."
The only limit may be the capacity of the market to crank out more deals, say market participants. "The buy side has hired so many experienced bank-side structurers and originators in the last six, eight months that the bankers I work with routinely are, in many instances, at the end of their rope, trying to keep up with the demand," says Chris Jackson, a structured finance partner at law firm Allen & Overy.
Meanwhile, a confluence of favorable market-spread conditions and robust CLO equity returns this year are fueling LCD's highest recorded levels of CLO refinancings and resets, keeping active aging portfolios, some as old as nine years
Year-to-date refinancing volume is $86.14 billion across 220 deals, and reset volume is $94.24 billion across 178 deals, according to LCD. The combined volume of $180.38 billion is already the highest yearly total since LCD began tracking refinancings and resets in 2016. Years with the prior highest previous volumes were 2017 ($167.01 billion) and 2018 ($155.89 billion).
The investor appetite for CLO paper continues to grow, even among reports that traditional investors such as Japan's Norinchukin Bank have bowed out or decreased their holdings in the U.S. CLO market. Increasingly standing in their absence are U.S. banks and insurance companies. BofA Securities recently reported that U.S. bank ownership of CLOs increased by 35% in the first half of 2021, while insurer holdings increased by 23% at year-end 2020, according to data from the NAIC.
"The consensus is that the current rate of [loan] default is 1%, give or take. Historically, the average is three. So that tells you we're in a really good spot," says Paul Travers, managing director and CLO portfolio manager for Sycamore Tree Capital Partners. "From the CLO world, where it's all about capital preservation, it's a good time generally to be investing."
While leveraged loan issuance since August has slowed from the blistering pace of June and July, institutional volume for the year stands at a record-pace $472.3 billion as of Sept. 24. LCD's net forward calendar for institutional loans has also ramped up recently, showing a net new supply (excluding anticipated repayments) of $20.3 billion slated to hit the market as of Sept. 22.
Approximately 78% of new-issue senior loans are pricing at or below par, giving managers plenty of maneuverability to issue deals at favorable net asset value.
Average spreads on triple-A tranches of CLOs widened slightly in the third quarter, to 117 basis points, compared to L+116 in the second quarter, but were still comparably smaller than spreads on the deal vintages from 2020, 2019 and 2017 — the primary sources of the heavy refinancing and reset activity that has occurred during the year.
In addition, says Bain's Wright, "Our fundamental view is that CLO liability spreads are wider than where they should be relative to other credit assets."
Looking ahead to the fourth quarter, new issuance is expected to continue ramping up at a brisk pace. In September, J.P. Morgan revised its 2021 new-issue projections to $145 billion-$155 billion, from the earlier range of $130 billion-$140 billion. S&P Global Ratings and BofA Securities during the quarter each raised their year-end new-issue forecasts to $140 billion.
One factor that could inhibit new-issue activity is capacity in the market, with participants warning of a logjam of deals. BofA also warned that primary activity might slow down late in the year because of the expected transition to a new Secured Overnight Financing Rate (Sofr) term benchmark for CLOs and leveraged loans.
A steep challenge forthcoming for managers will be negotiating credit-spread adjustment terms with investors on notes issued under Sofr terms. At issue is the wide gap between the 26 bps rate adjustment recommended by the Federal Reserve-convened Alternative Reference Rates Committee, and the current spot market difference of just 3 bps and 7 bps for the corresponding one-month and three-month Sofr and Libor rates.
"I think the general consensus is things could slow down a bit as we get to year end. Just because the uncertainty around Sofr is higher," says Travers.