The CLO market, especially equity investors, has had a lot to reflect on lately.
With the removal of risk retention for open-market CLOs, investors faced an increased supply in deals being marketed to them. Reset activity continues now that risk retention is no longer required. Citi projected $130 billion in resets in the U.S. this year. New managers have made their debut CLO in recent weeks.
While the market cheered the news regarding regulation, there has been an increase in senior liability spreads with the AAA coupon getting closer to 100bps. There is also a (London Inter-bank Offered Rate) LIBOR mismatch between the asset side versus the liability side. Approximately 60% of loans in the market is using the lower one-month LIBOR, while CLO debt is based on the higher 3-month LIBOR. The debt investors will not be open to documentation changes to switch to the lower LIBOR rate.
There is value in the liquidity of having more deals in the market and resetting existing deals, but the movement in liability spreads along with the LIBOR mismatch and puts stress on the equity returns and valuation. CLO equity investors will have pressure in evaluating new deals and valuation of existing investments in the coming months. As with any reset in the market, managers will have the opportunity to distinguish themselves.
Multi-front battle for CLO managers The recent backup in liability spreads comes as CLO managers fight a multi-front battle against tightening loan spreads and an increase in loan issuers switching reference rates from three month LIBOR to the lower one-month LIBOR. Spreads on BB loans reached new lows of L+210 bps in March, according to LCD data. If anything poses an issue for CLO equity investors going forward, it may be the widening between one month LIBOR and three month LIBOR. That basis as Nomura analysts wrote on Friday widened to 45 bps, levels last seen in 2010. If the wider basis incentivizes more loan issuers to make the switch, the analysts estimate that each additional 10% would lead to a fall in annualized equity distributions by 45 bps.