Falling CLO issuance hits US leveraged loan market

New York

SOME of the biggest buyers of company loans are scaling back, and it is hurting the market for buyout debt.

Money managers that buy loans and repackage them into bonds have cut back on their activity. Sales of the rebundled loans, known as collateralised loan obligations (CLOs), dropped 25 per cent in the first half of December from the same period last year, after falling 10 per cent in November.

The firms that issue CLOs buy about half the loans made to junk-rated companies. As demand from these money managers has waned, not to mention buying from retail investors, prices for leveraged loans have reached their lowest levels in more than two years.

The recent slowdown in CLO issuance - combined with loan price declines - underscore how the forces have inflated the loan market, and company debt more broadly, for more than two years can be fragile and fleeting.

"Things are on pause right now," said Lauren Basmadjian, portfolio manager at Octagon Credit Investors. "No one wants to catch a falling knife."

The knife is falling in part because the Federal Reserve is increasingly showing signs of slowing the pace at which it lifts rates. Loans and CLOs pay investors floating rates, so as the Fed hikes, they offer higher yields.

But once the central bank stops hiking and higher interest rates show signs of weighing on economic growth, loans can suffer. Those fears have spurred investors to pull money from loan funds at record rates, and have forced at least some banks to hold onto debt that they otherwise planned to offload.

Any pause in the market comes after a torrid year: issuance of new CLOs has reached a record US$127 billion in 2018. In 2017, that figure was closer to US$120 billion.

"There are still CLOs slated but the pace will slow down for the rest of the year because of the general market volatility. In addition, many people have already spent their money," said Vivek Mathew, head of asset management and funding at Antares Capital. He expects issuance to pick up again by the end of the first quarter.

Investors have poured money into loans in recent years to profit from the Fed's rate hikes. Leveraged loans that get packaged into CLOs offer additional protections to investors, because the portfolio of loans backing the securities has to sustain substantial losses before some money managers lose out.

Fed Chair Jerome Powell sees CLOs as a stabiliser of the leveraged loan market, not prone to engaging in "damaging fire sales". But the riskiest portions of CLO transactions may get hit hard if the loan market gets hurt, S&P Global Ratings analysts said in a report last month.

Money managers put together CLOs when it is profitable, in particular, when they can earn more from yields on their assets than they have to pay on their liabilities.

Lately, CLO yields have been rising - the average top-rated portion of a transaction was paying 1.22 percentage points more than a benchmark, up about 0.1 percentage points since the middle of the year, according to data compiled by Bloomberg News.

As profits fall for money managers from building CLOs, leveraged loan prices have fallen, bringing returns returns down 1.1 per cent this month including interest payments. Gains for the year for leveraged loans are still 1.9 per cent, which is still much better than other forms of corporate debt. High-yield bonds, for example, are up about 0.2 per cent for 2018, according to the Bloomberg Barclays US Corporate High Yield Total Return index.

While there have been some early signs of slowing growth in the US, the economy is still relatively strong. Normally, that might translate to investors snatching up bargains, but some money managers are hesitant to take new risk now.

"Going into year end, investors tend to be more cautious and protective of their profits and losses," said Steven Oh, head of credit and fixed income investments at money manager Pinebridge Investments. "In credit markets, ultimately there should be a point of stabilisation. But perhaps not this year." BLOOMBERG