Citigroup Inc. analysts have come up with Wall Street’s most bullish forecast yet for 2018 collateralized loan obligation sales: a record-breaking $140 billion.
Their assessment for new issuance indicates global demand for the securities isn’t relenting anytime soon, fueled by the yields on offer compared with other bonds, the analysts said. The debt, which bundles leveraged loans into bonds of varying risk and return, also tracks borrowing benchmarks, meaning the notes gain as interest rates rise.
Citigroup’s forecast significantly exceeds the next-highest 2018 prediction on the Street, Wells Fargo & Co.’s $125 billion estimate, and would eclipse a record $124 billion of sales in 2014. Strong CLO supply would build on 2017’s banner year for the debt, despite new risk-retention rules that were widely expected to quell the market. Last year ended with $119.85 billion of new issuance, as well as another $62.2 billion in resets and $103.36 billion in refinancings of older deals, according to data compiled by Bloomberg.
“We believe CLOs will be more mainstream in 2018,” Citigroup CLO analyst Maggie Wang said in a phone interview. “In the past it was more of an alternative investment. The relative value of the asset class is what’s attracting investors, in addition to the floating-rate benefit.”
Spread-tightening is also expected to continue, the bank’s analysts wrote in a Jan. 17 research note, with the AAA tranches of new CLOs likely tightening to as low as 75 basis points over Libor from a current average level of about 103 basis points. Even with expected tightening, steadily rising Libor will buoy the market to ever higher yields, luring new investors hunting for returns in a low-volatility, low-rate environment, the analysts said.
“More traditional investors such as insurance companies and mutual funds may start buying CLO investment-grade bonds,” Wang said. “They offer good relative value versus investment-grade corporate bonds and CMBS.”
Even if AAA premiums narrow to 75 basis points this year, a concurrent rise in Libor by 70 basis points would boost CLO AAA yields to more than 3%, an attractive prospect that will entice more investors, according to Wang.
At current Libor rates and taking into account expected spread tightening, AA-rated CLO bonds may earn a 3.4% yield, and yields on single-A slices could approach 4%, Wang said. Bonds rated BB may earn gains of as much as 10%, the analysts wrote in the report.
In addition to new CLOs, roughly $240 billion in old deals will be eligible to be either reset or refinanced this year, Wang said, although only approximately $150 billion will actually do so. Meanwhile, AAA spreads on short-term CLO refinancings and resets may decline to as low as 55 basis points over Libor, she said. Short-dated resets that also have a one-year non-call period could potentially price at less than 50 basis points above the benchmark, Wang said.
The evolution of the CLO market last year to include resets of older deals has given buyers even more paper to satiate their thirst for returns. Citigroup predicts $105 billion in resets this year, versus about $60 billion in 2017.
—Read Bond Investors’ Next Big Trade Is Betting on U.S. Homeowners on ThinkAdvisor.