CLOs Today Moderator: Meredith Coffey, LSTA Panelists: Wynne Comer, Bank of America Merrill Lynch Mary Katherine DuBose, Wells Fargo Tricia Hazelwood, Mitsubishi UFJ Jane Lee, Blackstone GSO Josh Terry, Highland Sajid Zaidi, Morgan Stanley
Presentation Overview CLO performance Issuance, outstandings, managers and investors Relative value CLOs vs. other investment vehicles: the role of the marginal buyer The regulatory overhang Outlook for the CLO market 2
CLO Performance 3
Loss rate (%) Default rate (%) Historical CLO performance strong on an absolute and relative basis Cumulative 5-year loss rates for Different asset classes Cumulative 10-year IG CLO vs. corp. default rates 45% 6% 40% 5.27% 35% 30% 5% 4% CLO Corp Bonds 25% 20% 3% 15% 2% 2.12% 10% 5% 1% 0.88% 1.16% 0.45% 0.47% 0% Global Corporates Global CLO US ABS ex HEL US CMBS ex CRE CDO US RMBS/HEL Global CDO 0% 0.00% 0.00% AAA AA A BBB CLO loss rates are among the lowest in investible asset classes The default rate on CLO notes is well below equivalently rated corporate bonds CLO AAA and AA notes have never suffered a default Source: Bank of America Merrill Lynch, Wells Fargo, Moody s, S&P 4
What it takes to impair a CLO note Breakeven Default Rates 70% Recovery 65% Recovery Annual Cumulative Annual Cumulative Class Default Rate Default Rate Default Rate Default Rate AAA 100.0% 98.8% 100.0% 98.8% AA 100.0% 98.8% 52.6% 97.6% A 37.1% 90.1% 28.9% 79.4% BBB 23.6% 73.0% 19.3% 64.4% BB 15.9% 58.8% 13.3% 51.0% Source: Wells Fargo 5
CLO Issuance, Outstandings, Managers and Investors 6
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Jan-Apr 2014 CLO issuance ($Bils.) CLO issuance is quite strong on an annual basis Annual U.S. CLO issuance 120 100 80 60 40 20 0 Source: Thomson Reuters LPC 7
Jan-11 Mar-11 May-11 Jul-11 Sep-11 Nov-11 Jan-12 Mar-12 May-12 Jul-12 Sep-12 Nov-12 Jan-13 Mar-13 May-13 Jul-13 Sep-13 Nov-13 Jan-14 Mar-14 Iss. ($Bils) AAA spread (bps) CLO issuance recovers post-volcker Monthly U.S. CLO issuance vs. AAA spread 14 180 12 Issuance Avg BSL AAA spread 170 160 10 8 6 4 2 150 140 130 120 110 100 90 0 80 Volcker Rule Source: Thomson Reuters LPC 8
CLO manager universe expands Repeat Manager More than 10 35% Manager breakdown for vintage 2014 CLOs New Manager 37% CLO MARKET ANALYSIS Repeat Manager 6-10 19% Repeat Manager 1-5 9% Source: Morgan Stanley
CLO AAA investor base changes AAA Investor base 2011-2013 AAA Investor base 2014 Asset Managers Hedge Funds Hedge Funds Pension Insurance Banks Asset Managers Banks Insurance Source: Citi 10
Jul-12 Aug-12 Sep-12 Oct-12 Nov-12 Dec-12 Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13 Jul-13 Aug-13 Sep-13 Oct-13 Nov-13 Dec-13 Jan-14 Feb-14 Mar-14 Apr-14 Outstandings ($Bils.) Outstandings ($Bils.) 350 300 250 200 150 100 CLO outstandings grow more slowly than issuance As older CLOs amortize and pay down U.S. CLO outstandings to date CLO 3.0 CLO 2.0 CLO 1.0 U.S. 1.0 and 2.0 forecast outstandings 350 300 250 200 150 100 CLO 2.0 CLO 1.0 CLO MARKET ANALYSIS 50 50 0-2012 Actual 2013 Actual 2014 2015 2016 2017 2018 2019 2020 CLO outstandings are growing more slowly CLO amortization is expected to quicken, putting further pressure on outstandings Source: Thomson Reuters LPC, Bank of America Merrill Lynch 11
CLO Relative Value 12
CLOs and relative value CLO 2.0 spreads CLO 1.0 AAA vs. 2.0 AAA 1,100 900 700 500 300 100 Jul-11Oct-11Jan-12Apr-12Jul-12Oct-12Jan-13Apr-13Jul-13Oct-13Jan-14Apr-14 AAA (150) AA (210) A (310) BBB (415) BB (610) CLO 2.0 AAA vs. CDX IG 16 190 170 150 130 110 90 70 50 Jul-11Oct-11Jan-12Apr-12Jul-12Oct-12Jan-13Apr-13Jul-13Oct-13Jan-14Apr-14 CLO 2.0 (150) IG (64) 300 250 200 150 100 50 Jul-11Oct-11Jan-12Apr-12Jul-12Oct-12Jan-13Apr-13Jul-13Oct-13Jan-14Apr-14 CLO 2.0 (150) CLO Secondary (90) CLO 2.0 AAA vs. CMBS 2.0/3.0 240 210 180 150 120 90 60 30 Jul-11Oct-11Jan-12Apr-12Jul-12Oct-12Jan-13Apr-13Jul-13Oct-13Jan-14Apr-14 CLO 2.0 (150) CMBS 2.0 (55) CMBS 3.0 (55) Source: Bank of America Merrill Lynch 13
The Marginal Loan Buyer and Impact on CLOs 14
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Loan fund flows ($BIls.) Inst. Market Share (%) CLOs and the marginal buyer: CLOs vs. funds Annual loan mutual fund flows very strong CLO and fund annual market share 70 80% 60 70% 50 40 60% 50% 30 20 10 40% 30% 20% 10% Loan mutual funds CLOs 0 0% -10 There was $60 billion of loan mutual fund inflows in 2013, pushing fund AUM to $175 billion Share of new issue loans purchased by mutual funds increased to 30% Source: Thomson Reuters LPC, S&P/LCD 15
Dec-11 Feb-12 Apr-12 Jun-12 Aug-12 Oct-12 Dec-12 Feb-13 Apr-13 Jun-13 Aug-13 Oct-13 Dec-13 Feb-14 Apr-14 Jan-12 Mar-12 May-12 Jul-12 Sep-12 Nov-12 Jan-13 Mar-13 May-13 Jul-13 Sep-13 Nov-13 Jan-14 Mar-14 May-14 Bid (% of par) Spread (bps) CLOs and the marginal buyer: Loan market impact Loan prices climb in secondary market Loan spreads contract in primary market 100 800 98 700 96 600 94 500 92 400 90 300 88 200 With strong demand both from CLOs and loan mutual funds, secondary loan prices climbed Similarly, all-in spreads (including LIBOR floor and amortized OID) trended down Source: S&P/LSTA Leveraged Loan Index, S&P/LCD 16
Jan-12 Mar-12 May-12 Jul-12 Sep-12 Nov-12 Jan-13 Mar-13 May-13 Jul-13 Sep-13 Nov-13 Jan-14 Mar-14 May-14 Jan-12 Mar-12 May-12 Jul-12 Sep-12 Nov-12 Jan-13 Mar-13 May-13 Jul-13 Sep-13 Nov-13 Jan-14 Mar-14 May-14 Spread (bps) Difference (bps) CLOs and the marginal buyer: Impact on arbitrage Loan spreads have contracted More than CLO costs Thus, the arbitrage has Become more challenging 650 500 600 550 450 500 400 450 400 350 Loan Spreads CLO Costs 350 300 Difference 300 250 250 200 200 150 150 Source: Bank of America Merrill Lynch 17
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 1Q14 Jan-12 Mar-12 May-12 Jul-12 Sep-12 Nov-12 Jan-13 Mar-13 May-13 Jul-13 Sep-13 Nov-13 Jan-14 Mar-14 Fund flows ($Bils.) Share of market (%) But what do slower loan mutual fund flows mean for CLOs? Mutual fund flows turn negative in April 2014 Loan fund new issue share falls in 1Q14 9 80% 8 7 6 5 4 70% 60% 50% 40% 3 30% Loan mutual funds 2 20% CLOs 1 0 10% -1 0% -2 Source: S&P/LCD, Thomson Reuters LPC 18
U.S. Regulation and CLOs FDIC Assessments Volcker Rule Risk Retention 19
FDIC Assessments The FDIC may assess an additional charge for U.S. banks that own CLO notes, regardless of the rating or quality of the notes The FDIC Assessment went into effect for CLOs issued after March 2013 The amount of the Assessment depends on the size of a number of exposures within the bank, and thus the Assessment differs from bank to bank 20
The Volcker Rule Banks are constrained from owning notes in 3c-7 CLOs that invest in bonds (or even have bond baskets) Rule was slated to go into effect July 2015 However, the rule was extended to July 2017, but only for notes owned by banks as of December 31, 2013 How has this affected the market? 21
$Bils. $Bils. U.S. CLO 1.0 and 2.0 outstandings: What will be outstanding in July 2017? Projected CLO 1.0 Outstandings Projected CLO 2.0 Outstandings 100 160 90 140 80 70 60 50 CLO 1.0 mostly repaid By July 207 120 100 80 Significant 2.0 outstandings In July 2017 40 60 30 40 20 10 20-2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024-2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 The extension of the Volcker conformance period basically removes the Volcker problem from CLO 1.0 There will be significant CLO 2.0 outstandings, which will need to be conformed or sold Source: LSTA, Bank of America Merrill Lynch, Intex
Thanks mostly to Volcker Rule, CLO investor base has changed significantly in 2014 AAA Investor base 2011-2013 AAA Investor base 2014 Asset Managers Hedge Funds Hedge Funds Pension Insurance Banks Asset Managers Banks Insurance Source: Citi 23
Risk Retention As written, Risk Retention would require CLO managers to retain 5% of the fair value of a new CLO s notes For a $500 million CLO, this would be $25 million Large managers and those affiliated with banks, insurance companies and PE firms may be able to issue some CLOs However, it could constrain issuance from smaller, independent managers Rule probably will not be finalized until 2H14 Risk retention is scheduled to go into effect for CLOs two years after final rules are written so probably not earlier than late 2016 24
Industry s proposed Risk Retention solution: The Qualified Open Market CLO A Qualified Open Market CLO (QCLO) that Meets Strict Criteria Would Require the Manager to Retain 5% of the Equity of the CLO A QCLO Requires a very significant funded cash investment by the manager Tightens and codifies best practices for the CLO market Encourages high quality underwriting Creates a series of six overlapping protections for investors and restrictions for managers Allows the CLO market to continue to function through a consensual arrangement QCLO protections include Asset quality constraints Asset portfolio protections Structural requirements, including minimum equity Alignment of interest between managers and investors Regulation of manager Transparency and disclosure requirements 25
Outlook for the CLO market Issuance now and in the future CLO spreads and arbitrage Investors Impact of regulation on the CLO market 26