The US$1.3 trillion ($1.76 trillion) collateralised loan obligation market is about to become a victim of its own success because managers can’t create the bonds fast enough to meet demand and are running out of things to buy.
A slowdown in mergers and acquisitions after borrowing costs rose is continuing to deprive the lenders of the leveraged loans that the industry was built on. About US$311 billion of M&A deals have been announced and completed so far this year, roughly US$1 trillion below the same level two years ago when interest rates began to rise, according to data compiled by Bloomberg.
That may soon end up impacting the equity arbitrage — the gap between the yields that CLO managers can earn on the loans they buy and the bonds they sell — which may hurt new issuance in the coming months. It’s also sent more managers into the secondary market, where about 60% of loans now trade above par, making it that much harder to find bargains to put together a portfolio.
“There’s too much demand for CLO bonds and too little loan supply. CLO managers can’t keep up much longer,” said Pratik Gupta, who leads CLO research at Bank of America Corp. “It’s becoming a challenge.”
Demand for the safest CLO tranches soared this year after an influx of money into exchange-traded funds. Banks have also been piling into the AAA bonds, and some Japanese institutions may scoop up more of the debt. On top of that, Bank of America estimates that about US$64 billion of the debt has been paid back so far this year, including amortizations and called CLOs, meaning asset owners have more capital to put to work.
“If you’re an existing investor, you’re getting so much money in the door that’s creating demand in and of itself,” said Amir Vardi, a managing director at UBS Asset Management, at the Global ABS conference in Barcelona earlier this month, referring to amortizations and called CLOs.
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“Forget about increasing the budget to get more,” he said on a panel. “You’re just trying to keep what you have invested.”
Demand is so strong that even an 86% increase so far this year in US sales of new issue CLO bonds from the same period in 2023 hasn’t been enough to sate investors’ appetite. As a result, spreads on the AAA debt have compressed by more than 100 basis points over the benchmark since late 2022, when the tranches were reaching eye-popping levels that made equity returns unattractive for investors.
Lenders are also trying to circumvent the dearth of paper by increasing their holdings of corporate bonds — both investment-grade and junk — in an attempt to preserve arbitrage returns, Gupta said. The rise of private credit is also crimping opportunities for leveraged loan lenders by winning business from them, even as Barclays Plc forecasts M&A volume to grow by as much as 20% over the next 12 months.
“The supply and demand balance is out of whack, it’s become more difficult to find assets at attractive levels,” said Christina O’Hearn, portfolio manager for the leveraged loan and CLO business at Pretium Partners. “We expect to see continued refi and reset activity but not as many new issue CLOs.”
