Dual Tranche Deals Come Out Of The CLOset
January 12, 2009
To combat a CLO market frozen stiff by a lack of new capital, price declines, and waning confidence, some firms are working on new CLO portfolio strategies to bring in business and keep current clients interested in the loan market.
Citigroup, Morgan Stanley, Natixis, JPMorgan, Prudential, Barclays and Deutsche Bank are some of the firms creating new CLO structures that have just two tranches, sources said. In this structure, one tranche is all triple-A debt and the other is equity-a nomenclature for unrated debt. These structures differ from the multi-tranche CLOs that helped balloon the securities market to more than half a trillion. Those CLOs had everything from mezzanine to triple-C tranches.
So far, these firms have not finalized a CLO using the two-tranche structure, because the loan market is still frozen. However, once the market thaws, demand for new products will come from a new crop of investors, such as pension funds, sources said.
"Many bankers we have spoken to tell us they want to structure deals with one triple-A tranche and one equity tranche, so they don't have to bother trying to sell mezzanine tranches," said Bill May, a managing director at Moody's Investors Service.
The split between the triple-A and the equity portions will not be straight down the middle, sources said. Some CLOs may be one part equity and two parts debt while others are mixed differently. Whatever the mix, the reasoning behind the structure is clear: to lower the CLO's leverage. Most multi-tranche CLOs were packed with debt used to back highly-levered mergers or acquisitions.
"The whole notion of the CLO has changed," said Eduard Trampolsky, vice president of structured credit strategy for Citi and an author of Citi's CLO Monitor, an analysis of the CLO market. "Forget the structures with thin tranches and long reinvestment periods. We're going to see some really plain vanilla, static structures with just two tranches."
In fact, these new structures are not new at all. Many of the CLOs in the '80s were mixed like this and had leverage ratios around 1x or 2x, not the 5x-plus the market saw during the LBO boom years, sources said. One reason these CLOs didn't remain in vogue, they said, was that the demand for loans outpaced the supply during the '90s and most of the current decade. As such, more highly levered, multi-tranche structures were fed to investors instead.
The prices on those assets have fallen at a breakneck pace, and the CLO market has been crippled with insecurity. Moreover, CLO managers are faced with an oncoming wave of downgrades, which will push single-B, double-B and even some triple-B buckets down to the triple-C category. Most CLOs can only carry so many triple-C-rated assets before senior debt holders have to divert cash or are repaid.
While the situation may seem dire, some CLO managers still see the value in the CLO market. "I was talking to a trader on a desk that bought a couple of CLO equity positions around $6 and traded them at around $10. That's an incredible opportunity," said a New York-based banker. "The issue is capital, and, well, read the newspapers."
Triple-A loans, sources said, are trading between Libor plus 400 bps and Libor plus 600 bps, which is an unprecedented range-speculative-grade debt used to trade at those levels. Moreover, considering where many speculative-grade loans are now trading, one would assume these assets are distressed and that the corporate default rate will skyrocket past 50%. But most market participants say such a high default rate is very unlikely, even in the worst of downturns.
"Hopefully people are realizing that there is value to be had," said a New York-based investor.
Indeed, JPMorgan reportedly added more than $1 billion of triple-A-rated CLO paper to its balance sheet at around 80 cents on the dollar between November and December. The bank already had approximately $14 billion of these investments on its balance sheet.
The triple-A tranches JPMorgan bought yielded between 2.8% and 4.7% over Libor. While that may seem like a low return-especially considering the fact that the average loan yielded between 5% and 10% over Libor from 2004 to 2006, according to the Standard & Poor's/Loan Syndications and Trading Association loan index-some investors now are actually losing money investing in the safe harbor of U.S. Treasurys.
"I've seen all sorts of nontraditional investors like pension funds, even equity investors, interested in this market because of the unbelievable value," said a Canada-based investor. "Who knows what the New Year will bring."
As 2009 progresses, a new, even more nontraditional investor may surface. Some market participants speculate that if market conditions worsen, the Federal Reserve or the Treasury Department may step in and help buy troubled CLOs.
"The Federal Reserve and Treasury will have to address the CLO market," said a banker at a large international bank.
One investor said that there is a $900 million government-backed OWIC that is looking for CLO paper. Calls to the Federal Reserve and to the Treasury Department were not returned by press time.
"Though CLOs are not the focus of government programs, once TALF starts purchasing student debt and credit card triple-As, CLO spreads will likely contract in sympathy," said Citi's Trampolsky.
(c) 2008 High Yield Report and SourceMedia, Inc. All Rights Reserved.