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September 10 2010
CLO Market Review
The CLO market ($260 billion) owns roughly 54% of the outstanding
institutional loan market ($481 billion) of which 69% ($333 billion) is
maturing between 2010 and 2014. In this report, we discuss the
issues, a few likely solutions, and why we believe this will have a
minimal impact on defaults and the CLO market.
Stocks fell in August with the Dow Jones Industrial Average falling
4.3% from 10,466 on July 30 to 10,015 on August 31. Likewise, the
S&P 500 fell 4.7% from 1,102 to 1,049 during the same period.
August was a busy month for the CLO market with BWIC volume
rising from $819 million in July to $1,246 million in August.
Our view remains the same as last month: we are medium to long-
term bullish on the loan market and therefore we are medium to long-
term bullish on CLOs up and down the capital stack. Bullish investors
should take advantage of bonds with longer duration as these will
Justin Pauley provide greater price appreciation as spreads tighten.
MBS, CMBS & ABS Strategy
+1 203 897 4619 We continue to believe that buy and hold investors should capitalize on
justin.pauley@rbs.com the economic recovery with double-Bs and equity (both low dollar and
strong cashflowing equity). Both trades offer significant upside in the
www.rbsm.com/strategy long term and are likely to continue rallying in the medium to long-term.
The Royal Bank of Scotland
The inflows to high-yield mutual funds fell to $1.52 billion for August
from July’s $2.79 billion. However, $1.52 billion is still much higher
than June’s $262 million. The high-yield bond inflows on August 25
($315 million) represented the seventh straight week of inflows. The
inflows to bank loan mutual funds moved from $296 million in July to
$405 million in August. The $142 million of bank loan inflows on
August 25 represented the eighth straight week of inflows.
For the first time this year, the lagging twelve-month LSTA loan index
default rate rose slightly, from 3.47% in July to 3.57% by volume after
Oriental Trading filed a Chapter 11 reorganization plan. Nevertheless,
the default rate is still lower than June’s level of 4.02% by volume. We
believe that the default rate will continue to fall though 2010.
Defaulted and Caa1-Ca buckets (our proxy for the triple-C bucket) in
CLOs scarcely budged in August with the default rate moving from
2.8% in July to 2.6% in August. CLO exposure to defaulted assets
remained at 7.4% during the same period.
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The Royal Bank of Scotland
The Problem
To be put simply, the problem is that the CLO market ($260 billion)
owns roughly 54% of the outstanding institutional loan market ($481
billion) of which 69% ($333 billion) is maturing between 2010 and 2014.
Specifically, 43% ($207 billion) is maturing in 2014 and 18% ($88
billion) is maturing in 2013. This problem exists because the market
conditions in 2006-2007 allowed for a great deal of CLO issuance and
thus high demand for leveraged loans.
If these issuers cannot Investors are concerned that issuers will not be able to refinance due
refinance or extend their loan to an insufficient primary CLO market and light demand for leverage
they will be forced to default. loans relative to the number of outstanding CLOs that are ending their
reinvestment period (Figure 1). Moreover, if these issuers cannot
refinance or extend their loan they will be forced to default.
100%
$200 Billion
80%
$150 Billion
60%
$100 Billion
40%
$50 Billion
20%
0% $-
Q1-2010
Q2-2010
Q3-2010
Q4-2010
Q1-2011
Q2-2011
Q3-2011
Q4-2011
Q1-2012
Q2-2012
Q3-2012
Q4-2012
Q1-2013
Q2-2013
Q3-2013
Q4-2013
Q1-2014
Q2-2014
Q3-2014
Q4-2014
These solutions, discussed Fortunately, there are a few solutions to this problem. These solutions,
below, have helped reduce the discussed below, have helped reduce the 2010-2014 wall of maturities
2010-2014 wall of maturities from $521 billion on 12/31/2008 to $418 billion on 12/31/2009 and
from $521 billion on 12/31/2008 finally $333 billion on 8/20/2010 (Figure 2). The bulk of the reduction
to $333 billion on 8/20/2010. was focused on the loans maturing in 2013, ($174 billion on 12/31/2008
to $88 billion on 8/20/2010).
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The Royal Bank of Scotland
250
150
100
50
-
2010 2011 2012 2013 2014 2015 2016 2017
12/31/2008 12/31/2009 8/20/2010 Pro Forma for HY Paydowns
Source: LCD
Figure 3 shows how the wall of maturities for loans maturing in 2010
through 2014 has been reduced over time.
600
500
400
300
200
100
-
12/31/2008 12/31/2009 8/20/2010 Pro Forma for HY
Paydowns
Source: LCD
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The Royal Bank of Scotland
Loan Funds - As we will discus in greater detail later in this report, loan
funds have had eight straight weeks of positive inflows. This capital
may be put to use to help issuers refinance their outstanding debt.
IPO/M&A – Some issuers have filed paperwork for an IPO that may
lead to loan repayment or, at least, improve their balance sheet. In
addition, companies acquired by corporate issuers with cash may
repay.
5
The Royal Bank of Scotland
60
50
40
30
20
10
-
Paydowns Partial paydowns HY takeouts Defaults A-to-E
2009 YTD 2010
Source: LCD
Source: LCD
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The Royal Bank of Scotland
At that rate, the wall should be We believe that, at this rate, the wall of maturities will crumble without
reduced to an acceptable size causing the default rate to spike. Figure 6 shows the amount of
by 1Q2012. Therefore, we reductions in the 2010-2014 wall of maturities by quarter. It does not
80
70
60
50
40
30
20
10
-
3Q09 4Q09 1Q10 2Q10 Jul-Date
Source: LCD
Nevertheless, we do warn that Nevertheless, we do warn that issuers rated triple-C or less may find it
issuers rated triple-C or less difficult to avoid default due to their in ability to access the capital
may find it difficult to avoid markets and investors should avoid CLOs with large triple-C buckets.
default due to their in ability to Figure 7 shows that triple-C and below loans only makes up 5% ($16
access the capital markets. billion) of loans that mature through 2014 whereas single-B loans
maturing through 2014 make up 63% ($211 billion) of the wall.
Comparing to previous years, triple-C or lower on 12/31/2009 made up
$36.4 billion of the wall and on 12/31/2008 triple-C or lower made up
$40.5 billion of the wall through 2014.
250
200
150
100
50
-
BBB BB B CCC/CC/C NR
Due Through 2013 Due Through 2014
Source: LCD
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The Royal Bank of Scotland
Back on Track
Regardless of the performance News of slowing domestic and global economies led stocks to fall in
August was a busy month for the CLO market with BWIC volume rising
from $819 million in July to $1,246 million in August (Figure 8).
Moreover, August, unlike July, did not have any CLO packed
liquidations.
800
700
600 Stanton CDO Liquidation July 13
500
400
300
200
100
-
1
5
.W
.W
.W
.W
.W
W
W
st.
st.
st.
st.
st.
ly
ly
ly
ly
ly
Ju
Ju
Ju
Ju
Ju
gu
gu
gu
gu
gu
Au
Au
Au
Au
Au
Source: RBS
* Generic levels for 2006-2007 paper with 6-year reinvestment periods Source: RBS
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The Royal Bank of Scotland
The entire capital stack costs less than the underlying pool of loans.
We continue to believe that buy We continue to believe that buy and hold investors should capitalize on
and hold investors should the economic recovery with double-Bs and equity (both low dollar and
capitalize on the economic strong cashflowing equity). Both trades offer significant upside in the
recovery with double-Bs and long term and are likely to continue rallying in the medium to long-term.
equity. Moreover, equity investors will benefit from the excess spreads from
the LIBOR floors in new issue loans (total spreads around 700 bps for
single-B loans).
Triple-A CLO notes, in (or near) Triple-A CLO notes, in (or near) post-reinvestment, are recommended
post-reinvestment, are for accounts looking for short and safe cashflow as we view these as
recommended for accounts money good regardless of economic conditions.
looking for short and safe
cashflow as we view these as Loan Market Update
money good regardless of
economic conditions. Almost all of the statistics we use to measure performance in the loan
market remained unchanged in August. Given the amount of decline
and volatility in the equity market, we view unchanged as a positive
result. One other positive news item in August is that inflows to bank
loan mutual funds remain strong. Figure 10 shows inflows to bank loan
mutual funds moved from $296 million in July to $405 million in August.
The $142 million of bank loan inflows on August 25 represented the
eighth straight week of inflows. The inflows to high-yield mutual funds
fell to $1.52 billion for August from July’s $2.79 billion. However, it is
still much higher than June’s $262 million and the high-yield bond
inflows on August 25 ($315 million) represented the seventh straight
week of inflows.
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The Royal Bank of Scotland
Figure 10: High-yield and Bank Loan Mutual Fund Flows ($mm)
4,000
Source: AMG/Lipper
100
95
90
85
80
75
70
65
60
55
3/1/10
3/8/10
3/15/10
3/22/10
3/29/10
4/5/10
4/12/10
4/19/10
4/26/10
5/3/10
5/10/10
5/17/10
5/24/10
5/31/10
6/7/10
6/14/10
6/21/10
6/28/10
7/5/10
7/12/10
7/19/10
7/26/10
8/2/10
8/9/10
8/16/10
8/23/10
8/30/10
Source: LCD
For the first time this year, the lagging twelve-month LSTA loan index
default rate rose slightly from 3.47% in July to 3.57% by volume after
Oriental Trading filed a Chapter 11 reorganization plan (Figure 12).
Nevertheless, the default rate is still lower than June’s level of 4.02% by
volume. As Oriental Trading was already in default on its second lien
the default rate by number of loans was not affected. The lagging
twelve-month default rate by number of loans dropped from 4.91% to
4.66%. We believe that the default rate will continue to fall though 2010.
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The Royal Bank of Scotland
12%
8%
6%
4%
2%
0%
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Default Rate by Volume Default Rate by Count
Source: LCD
Defaulted and Caa1-Ca buckets (our proxy for the triple-C bucket) in
CLOs scarcely budged in August with the default rate moving from 2.8%
in July to 2.6% in August. CLO exposure to defaulted assets remained
the same at 7.4% during the same period. Figure 13 shows the combined
buckets slightly dropping from 10.2% to 10.0%. This information comes
from trustee reports which are often lagged. For this analysis we included
569 CLOs with an average trustee report date of 7/28/2010.
16%
14%
12%
10%
8%
6%
4%
2%
0%
Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10
Defaults + Caa1-Ca
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The Royal Bank of Scotland
14%
10%
8%
6%
4%
2%
0%
Senior OC Cushion Minimum OC Cushion
Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10
Tell-tale Signs
In August, Moody’s upgraded Rating actions are typically one of the best and generally most lagged
90 tranches from 26 CLOs and indicators of performance in the CLO market. When Moody’s originally
did not downgrade a single 2,071 tranches early last year, it was right after CLOs hit rock bottom,
CLO tranche turned a corner, and started down the path to recovery. In August,
Moody’s upgraded 90 tranches from 26 CLOs and did not downgrade a
single CLO tranche (Figure 15). They upgraded more than twice the
amount they upgraded in July (42). The majority of these upgrades were
the result of delevering of the tranches and improvements in OC tests.
Baa2 - - - - - - 1 - - - - - - - - - - - - - -
Baa3 - - - - - 2 1 3 2 - - - - - - - - - - - -
Ba1 - - - - - - - - 2 4 - - - - - - - - - - 2
Ba2 - - - - - - - 1 1 3 1 - - - - - - - - - -
Ba3 - - - - - - - - - 1 4 3 - - - - - - - - -
B1 - - - - - - - - - - - - 1 - - - - - - - -
B2 - - - - - - - - - - - - - 2 - - - - - - -
B3 - - - - - - - - - - - - - 2 3 - - - - - -
Caa1 - - - - - - - - - - - - - - 1 2 - - - - -
Caa2 - - - - - - - - - - - - - - - - 2 - - - -
Caa3 - - - - - - - - - - - - - - 1 - 3 1 - - -
Ca - - - - - - - - - - - - - - - - - - 4 - -
WR - - - - - - - - - - - - - - - - - - - - -
Source: Moody’s
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The Royal Bank of Scotland
While S&P has not upgraded any tranches in August, it has not
downgraded any either. We believe that S&P will follow Moody’s and
by this time next year both rating agencies will have similar ratings.
Source: CreditFlux
We believe the CLO market will As we have mentioned in pervious reports, while we expect a few new
eventually come back in order issue deals to price, we do not expect new issuance to return in any
for corporations to grow, meaningful way until secondary CLO prices rise enough to make new
operate, and thrive. issue arbitrage deals more attractive. The recent widening in CLO
liabilities and concerns over the impact of regulatory issues will make it
difficult for new issue deals to come to market in the short-term.
However, we believe the CLO market will eventually come back in
order for corporations to grow, operate, and thrive.
Conclusion
Although the equity markets took a hit in August, the loan and CLO
markets held up. While the loan markets remained relatively
unchanged, CLO levels continued to rally even with a large amount of
supply from BWICs.
While every month we see more and more news on CLO issuance, we
do not expect new issuance to return in any meaningful way until
secondary CLO prices rise enough to make new issue arbitrage deals
more attractive. However, we believe the CLO market will come back in
order for corporations to grow, operate, and thrive.
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The Royal Bank of Scotland
The author of this material is a desk strategist, salesperson or trader and will be compensated based in part on the author’s own performance, the
firm’s performance, the performance of the sales or trading desk for which the author works and/or revenues from the firm’s general investment
banking activities. This material is informational only, and is not intended as an offer or a solicitation to buy or sell any securities or other
financial instruments. It is not considered research and is not a product of any research department. RBS Securities, Inc. is not, by making this
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