By mid-September, the US leveraged loan market had racked up its 21st week of outflows over the previous 23 weeks, according to research firm Lipper – $11.4 billion had been withdrawn from the market over that period.
This money is predominantly leaving bank loan funds after a record-breaking 95-week inflow streak that totalled $66.7 billion.
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| CLO managers will finance to meet risk-retention capital requirements and this will open the door to new opportunities Jean-Philippe Levilain |
Year-to-date fund flows into leveraged loans are negative $4.4 billion, based on a net withdrawal of $4.9 billion from mutual funds against a net inflow of $442 million to exchange-traded funds (ETFs). This time last year, inflows had totalled $43 billion, with 11% tied to ETFs.
That retail money is getting nervous about leveraged loans is obvious – thanks in part to Federal Reserve chair Janet Yellen’s vocal concern over the risks now embedded in leveraged finance and the enforcement of stricter lending guidelines by the Office of the Comptroller of the Currency.
However, while headline outflows of such magnitude have attracted much attention, not everyone in the market is sorry to see the retail exodus. Indeed, the CLO market – which has seen record volumes of issuance in 2014 – welcomes it.
“A technical factor that the market faces is the outflows from retail,” says Matt Natcharian, head of structured credit at Babson Capital. “Retail outflows can be good for CLOs as it is much easier to ramp a deal with loans at 99 than it is with loans at par.”
Babson has $13.4 billion in cash-flow CLOs under management.
Jean-Philippe Levilain, head of US structured finance and US high-yield corporate loans at Axa Structured Finance, adds: “There is limited risk that outflows from loan mutual funds could lead to a significant fall in prices, because for bank loans there are plenty of alternative buyers that have very little mark-to-market leverage employed at the moment.”
Axa closed it first US CLO in February – a $370 million deal dubbed Allegro, which is backed purely by corporate assets.
“Widening spreads would therefore be met with excess demand from other long term buyers,” says Levilain. “There might be a short-term shock, but this would be a good development in the medium term.”
He agrees the outflows can be seen as good news for CLO managers, adding: “The trends on the retail side and the CLO sales side are quite opposed – there are conflicting constraints and targets.
“In a way, outflows are good for CLOs. They lead to a widening of spreads and a drop in the price of loans which contribute to a better arbitrage in the CLO structure and also leads to greater availability of paper. New CLO loan issuance in the last three months has been at spreads around 50 basis points wider than at the beginning of the year.”
Awaiting clarification
This potential improvement in deal economics comes as the US CLO market still awaits final clarification of risk-retention rules, which were expected shortly after Labour Day – September 1 – but by the end of the month was still not forthcoming.
Senator Daniel Tarullo surprised the market mid-month by stating that while regulators were “in the home stretch” he “can’t say [that they will be finished] by the end of the year”.
This is substantially later than the market has been expecting. The House passed HR 5461 on September 16, which brings some relief to CLOs under the Volcker Rule, but it is the final rules on risk retention that the market needs to see now.
More than $85 billion of deals have been arranged in the US so far this year and Bank of America Merrill Lynch recently increased its full-year forecast to $110 billion, which would beat the $93 billion of business that was inked just before the market crash in 2007.
| Some managers have tried to do as many deals as they can before the risk-retention rules are finalized Matt Natcharian |
This surge in business has been attributed partly to investor demand for floating rate products and partly to a desire by CLO managers to get deals out of the door before the final risk-retention rules come into force.
“During the last year we have seen huge supply,” says Babson’s Natcharian. “Some managers have tried to do as many deals as they can before the risk-retention rules are finalized, but this has not been the main driver of the market. Most larger managers will not be affected by the rules as they have sufficient capital.”
However, the rules will necessarily lead to consolidation in the market.
“Investors are already saying that once the US risk-retention rules are published, they don’t want to invest with managers that won’t be able to compete in two years’ time when the rules come into force,” says Dagmar Kent Kershaw, head of credit fund management at ICG in London. “This could force consolidation among smaller managers without access to capital.” ICG has issued two US CLOs this year.
What it could and is already doing is forcing smaller managers to borrow in anticipation of higher capital requirements: in effect encouraging these structures to lever up in order to become less risky. This is yet another example of the perverse impact that some regulation is having on the credit markets.
“Some smaller managers have been able to get financing to deal with the capital requirements of risk retention,” says Natcharian. “However, this changes the risk incentives for the manager as the business model is now leveraged.”
It is also an opportunity for existing, strongly capitalized players to make money.
“CLO managers will finance to meet risk-retention capital requirements and this will open the door to new opportunities,” says Axa’s Levilain. “In financing that retention it is likely that lenders can extract value – positioning themselves at the core of the business model and being able to extract warrants or equity-like returns.”
