Over the past few years, the ABS Vegas conference has been the place for industry participants to congratulate each other on a job well done (most recently on a record-setting 2015 for CLO primary issuance), meet-and-greet with clients and generally unwind, making sure to sprinkle a few “important” meetings across the three-day span. However, following a January and February where CLO primary issuance was down well over 50% year-over-year with little sign of an upturn before the conference, most of us went into ABS Vegas 2016 with uneasy feelings.
But, we are happy to report we were pleasantly surprised. “Like father, like son” can appropriately be borrowed here and twisted into “like product, like banker” because, similar to the performance of CLOs throughout the financial crisis, the prevailing attitude among CLO bankers and structurers in attendance can be summed up with one word: resilient. Notwithstanding a rash of bad news (e.g., recent Oil & Gas downgrades and potential bankruptcies on the horizon), negative trends (e.g., the YTD decline in the Leveraged Loan 100 Index) and strong headwinds facing the CLO market (e.g., Risk Retention and the resultant market uncertainty), on average attendees and panelists alike carried a cautiously optimistic tone with one veteran CLO structurer putting it bluntly: “2016 is not 2008 and only 10 deals have priced in the first two months – we can only go up from here.” (Since that statement was made, 10 more deals have priced and in the span of two weeks, not two months. Right on, up we go.)
An interesting barometer of near-term negativity coupled with medium-term opportunity was the abundance of meetings. It seemed every time you ran into a client or scheduled a drink, it was quite literally limited to “running into” or just “a drink” as everyone had another meeting in 5 minutes. It makes sense. With primary deals stalled and the supply of secondary CLO paper plentiful, everyone was meeting with someone in order to get the primary market back up and going again.
Feeding off measured confidence that the 2016 primary market will eventually start its engine, much of the focus of the panels, the meetings and even the cocktail party banter turned to identifying the trends and issues that will be affecting the CLO market once “The Great Freeze of Q1 2016” begins to thaw. These major trends and issues are outlined below:
- The Relative Value Play in the Secondary market Will End and Risk Retention Will Get Figured Out: To date, the story of Q1-2016 has been twofold. From a fundamentals perspective, the relative cheapness of CLO secondary paper as compared to primary issuances (especially triple-Bs and double-Bs) has sapped demand for new deals. From the regulatory side of things, investors are hesitant to get into bed with managers who cannot solve Risk Retention and, as such, are generally taking the wait-and-see approach as mangers, investors and underwriters work together to figure it out. Since the conference, Japan has gone negative on rates stoking hopes we may see more Japanese banks as buyers going forward (buyers who traditionally buy in the primary market) and just this past week an industry publication noted that the selling frenzy of triple-As in the secondary market may be coming to an end, which theoretically should divert the banks and insurance companies on the other side of those trades back to the primary market as well. With respect to Risk Retention, almost all market participants believe that the Risk Retention issue will be solved after a brief period of manager consolidations and the successful initial roll out of various Risk Retention platforms over the course of 2016.
- Supply, Supply, Supply… While very few people expected primary issuance this year to match the monster numbers put up last year, it is safe to say even fewer people expected the paltry Q1-2016 numbers we have seen thus far. What goes hand-in-hand with an overestimation of investor demand? Unfortunately, an oversupply of warehoused assets with no place to go. Various numbers were thrown around throughout the conference but a nice round one I heard often is 90 – over 90 warehouse lines of credit holding CLO assets that managers have outstanding with banks, a portion of which are at least partially underwater at current prices. When the market starts back up, an outstanding issue is what happens to these warehouses? Thus far, we have been seeing some banks agree to extend the term of some of these warehouses, but in many of these amendments those same banks are using their strong negotiating position to tighten up some of the deal terms and almost universally lowering the leverage permitted across the board. Other than the “amend to extend” option, what are the other options? Do the managers and/or the warehouse equity take the hit on rolling over the warehouse in an effort move the deal forward? Is there a “bad warehouse”/“good warehouse” solution to be had? These are interesting questions that will be answered sooner or later. Until then, print-and-sprint will be the new norm on account of excess backlog of underwater warehouses.
- Oil & Gas, Metals & Mining – Time for Bargain Hunting or Paring Risk? It has been well covered that two sectors, Oil & Gas and Metals & Mining, are extremely challenged right now. Considering that most are still more negative than positive on China (pressure on Metals & Mining) and the price of oil (pressure on Oil & Gas), over the short and intermediate term the question becomes: is it a time for managerial defensiveness or an opportunity to take advantage of fear-driven pricing opportunities creating value in these beaten-down sectors? Most at the conference preached defensiveness. Sit tight, hunker down and wait it out; live to fight another day, so to say. Others took a more calculated approach stating it depends on the manager and depends on the various investors in any given deal. In their view, if the manager has the expertise and the investors have the risk tolerance, take this opportunity to build excess par and provide flexibility in the deal down the road.
- A Return to the Land of CLO 1.0 – Consolidation and Sticky Money: Many participants predicted a general return to the CLO 1.0 landscape: manager consolidations in the market will lead to fewer managers, and on account of risk returns the manager-investor relationship will extend beyond single deals. This will lead to bigger deals with stickier money, likely via top-level, long-term relationships between managers and investors.
- Other Tidbits:
“Fallen Angels” from the Bond World: On account of the Volcker Rule and widespread “Volcker compliance” in the CLO space, managers can’t buy Fallen Angels simply because they are bonds. However, as mentioned during at least two panels, some of these names are very, very attractive right now and have attractive yields on account of the forced-sale by certain Investment Grade bond investors creating downward pressure on price and lots of opportunity. Wouldn’t it have been nice if sophisticated managers could have picked up some value in Fallen Angels to offset the hit they will likely have to take on account of the Fallen Devils (See Below)?
“Fallen Devils” of the Loan Market: Large number of downgrades on single-B names will may lead to market-wide pressure on the Caa/CCC buckets (typically 7.5%) in CLOs and, as a result, eat away at the par buffer of CLOs’ OC test as Caa/CCC excess starts to build. Watch out for OC pressure across deals, but especially those heavy in Oil & Gas or Metals & Mining.
- Parting Thoughts: The Macro View:
Market Sentiment: For a longtime now, big money has been in a “risk-off” position; even just a small uptick of market sentiment (U.S. credit-specific, macro/global or both) would really help improve the market outlook for CLOs over the near and medium-term.
Short-term: Over the short-term, there are still a lot of headwinds and more volatility to come (See Above).
Medium-term: If a global recession does not come to fruition over the next 12 to 18 months, then there is beautiful upside to the current yields on certain if not all tranches of CLOs.
Long-term: Managers and the market as a whole need to broaden and rethink (think, CLO 1.0 landscape (See Above)) the targeted investor base to lock-up stickier, more resilient money (i.e., less susceptible to volatility).
Conclusion: Eventually, many participants see manager consolidations, less fear in the market and risk retention arrangements going live as the main elements that will help to unfreeze and start back up the primary market issuance engine.
See you all in a few months in Miami, hopefully with bountiful transaction volume to reflect upon!