(Bloomberg) - The biggest US banks are stepping back into the $1.3 trillion market for collateralized loan obligations after nearly two years of shying away from investing in the securities.
An increase in deposits in recent months is prompting banks to seek out high-quality fixed-income assets to deploy money, market watchers say. The return of Wall Street buyers has pushed spreads well below year-end levels, jump-starting CLO creation and ginning up demand for loans. That could ultimately help leveraged finance desks better compete with private credit to finance buyouts.
“CLO liabilities have tightened,” said John Wright, global head of credit at Bain Capital Credit. “That begets CLO formation and that begets loan demand.”
Representatives for Citigroup and Bank of America declined to comment, while JPMorgan didn’t respond to a request seeking comment.
For years the global CLO market was dominated by Japan’s Norinchukin Bank, which at one point purchased nearly half of all AAA issuance. When the Japanese lender pulled back from CLO investing beginning around 2019 amid regulatory scrutiny, the largest US banks stepped in.
Yet wary of new capital rules and spooked by the blowup of Silicon Valley Bank, they had backed away. New investors ranging from Middle East buyers to Greek banks helped fill the void, but AAA prices remained wide and putting together CLOs profitably was challenging.
“We’re hearing that the banks are more active. Why were banks on pause last year and not now?” said Brendan Beer, co-portfolio manager of Oaktree Capital Management’s structured credit strategy. “The banks have more money now than they did in mid-2023.”
US banks’ securities holdings are on the upswing after tumbling from more than $5.8 trillion to a low of about $5 trillion late last year, according to a Bloomberg index of Federal Reserve data. The uptick coincides with an increase in deposits after they fell from a peak of about $18 trillion in the first part of 2022, according to a related index.
JPMorgan resumed buying CLO debt about a year ago but sporadically. BofA has also been investing here and there, and now intends to increase the amount.
In the US, Carlyle Group Inc. last week issued a new CLO with AAA debt yielding 1.53 percentage point over the benchmark rate — about 20 basis points tighter than on similar AAA debt it issued in November. Over in Europe, Fidelity and Sound Point Capital Management issued a new CLO with AAAs at 1.5 percentage point over the benchmark. Just last month, similar deals were pricing with spreads of around 1.7 percentage point.
Tighter spreads will likely encourage more collateral managers to launch new CLOs as they improve the arbitrage, or the difference between cost of funding CLOs and the returns on the underlying loans. CLO equity investors who decide whether to issue a deal stand to make more money the wider the arbitrage gets.
A resurgence in new CLO formation, in turn, could spur leveraged finance desks to underwrite deals at lower yields to better compete against direct lenders.
“When banks see that CLOs are opening a lot of warehouses and increasing demand for leveraged loans, that gives them confidence to underwrite at competitive terms against private credit,” said Boris Okuliar, co-head of global liquid credit at Ares Management.
Banks are looking to arrange debt packages for a number of high-profile leveraged buyouts currently seeking financing, including multibillion-dollar deals supporting the acquisitions of Cotiviti Inc., German metering firm Techem GmbH and DocuSign Inc., Bloomberg previously reported.
Tighter liabilities are also making it more attractive to reset, reissue or call older CLOs as managers rush to shed older, higher cost debt.
What’s more, with roughly 40% of CLOs nearing or exceeding deadlines for when they can buy new loans — known as their reinvestment period — more are returning capital to investors. Many money managers holding the securities are looking to reinvest the funds back into newly issued issued CLOs, adding to demand.
“The market will be very different in 2024,” said Lauren Law, portfolio manager at Octagon Credit Investors. “In contrast to 2023 and much of 2022, we anticipate more activity – more calls, more resets, more issuance.”
To be sure, even after rapidly tightening, current spreads of roughly 1.5 percentage point on CLO AAA bonds are still wider than their average of 1.36 percentage point between 2011 and 2020, a period when the volume of CLO debt expanded rapidly. Whether spreads fall far enough to compel not only plenty of resets and refis of existing debt but also growth in the overall size of the CLO universe remains to be seen.
Some fund managers are confident CLO creation will pick up in 2024.
“We’ll see more demand than a lot of the sell-side research is expecting,” said Lauren Basmadjian, global head of liquid credit at Carlyle. “Some are expecting a down year versus an already low issuance year. I think the projections are low.”
By Lisa Lee and Scott Carpenter
