Refi Surge Calls for Selective Buying
Direct lenders and middle market credit platforms will drive middle market CLO issuance.
The ABS market’s orderly response to the Hanjin bankruptcy suggests that the structured credit investor base has matured since 2007. Hanjin Shipping, Korea’s largest container carrier, filed for bankruptcy protection on Aug. 31, succumbing to the challenging combination of weak GDP growth and industry overcapacity. As Hanjin’s customers scrambled to recover stranded cargo and creditors braced for losses, the container lease ABS market responded with brisk trading, healthy liquidity, and nearly unchanged prices. Meanwhile, the CLO market rebounded in the third quarter. Volatility during early 2016 kept many CLO issuers on the sidelines. As a result, traditional CLO debt investors entered the third quarter well behind internal CLO spending targets. Adding to demand, investors continued to increase allocations to floating-rate CLO debt in response to rising USD LIBOR and negative yields in Japan and Europe. Not surprisingly, CLO spreads tightened significantly during the third quarter. Already hoping to issue or refinance CLOs ahead of the December 2016 risk retention deadline, CLO issuers were only too happy to meet strong CLO demand. September represented the highest monthly CLO issuance since June 2015, with October on track to exceed September.
CLO Spreads Hit 52-Week Tights
Several third-quarter trends caused CLO spreads to tighten significantly. Investors have been allocating more to floating-rate assets as three-month LIBOR rises, while yields in Europe and Japan fall deeper into negative territory. Growing demand and a looming risk-retention deadline led to a resurgence in supply that included refinancing activity, causing CLO spreads to tighten broadly. In a strong reversal from the end of the second quarter, CLO spreads across the credit spectrum are now at 52-week tights.
Source: J.P. Morgan, Guggenheim Investments. Data as of 10.24.2016.
The CLO market gained 2.58 percent on a total return basis in the third quarter of 2016, per J.P. Morgan’s CLOIE index. Post-crisis CLOs rose 2.63 percent, while pre-crisis CLOs rose 2.27 percent. Lower-rated tranches again outperformed higher-rated tranches this quarter with AAA, AA, A, and BBB post-crisis CLO tranches returning 1.28, 2.51, 4.48, and 6.40 percent, respectively.
We have largely ceased buying longer duration, deep mezzanine CLO tranches, as the dislocation of early 2016 has corrected. Meanwhile, the dizzying volume of refinancings has somewhat overwhelmed buyer bandwidth. In this environment, we are focusing on refinanced A- and BBB-rated tranches with limited remaining reinvestment periods. Over the past year, a number of strategic investors and insurers have acquired or partnered with direct lenders. These new partnerships and existing middle market credit platforms will drive significant middle market CLO issuance over coming months. Within esoteric ABS, employment and wage gains have impacted quick service and casual dining concepts with wildly variable results. As a result, we find some, but not all, whole business ABS issues attractive, as well as select aircraft lease ABS.
Monthly Refinanced CLO Volume Exceeds Non-Refi in October
CLOs issued in 2012 and 2013 have exited their non-call periods, prompting CLO equity holders to improve returns via refinancing activity. In the third quarter, refinancing activity represented 26 percent of volume, a trend that has continued into October. Refinanced tranches typically have shorter reinvestment periods, a feature that we find attractive given that we are in the late stages of the credit cycle. We have been focusing on A- and BBB-rated refinanced tranches with limited remaining reinvestment periods.
Source: S&P LCD, Guggenheim Investments. Data as of 10.15.2016.
—Brendan Beer, Managing Director; Michelle Liu, Director; George Mancheril, Vice President
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