Fitch: U.S. CLO & Leveraged Loan Boom Continues Amid Incredible Shrinking Spread.

NEW YORK -- Ever-tightening spreads have so far yielded little resistance to the enormous growth of both U.S. collateralized loan obligations (CLOs) and leveraged loans, according to Fitch Ratings. However, the very strong demand for loans, resulting from CLO growth, has driven yields lower, leading to some structural and credit deterioration that may result in choppier waters for both structures when the next economic downturn takes place.

Companies with limited access to alternative forms of capital, such as automotive suppliers, have also turned to CLOs as somewhat of a last resort, which raises questions as to whether the ultimate lenders are being adequately compensated for the risks as spreads compress at the lower end of the credit spectrum.

Addressing approximately 200 investors, bankers, researchers and asset managers at a recent CLO and loan conference, Managing Director Mark Oline said that 'defaults are likely to tick up, and in fact may even jump up in the coming years.' And despite the fact that the ratings mix of high yield loan issuance has become more aggressive, Senior Director William May said that 'covenant packages have been shrinking, weakening the constraints on borrower behavior and possibly sowing the seeds for problems down the road.'

These developments may lead to more uncertainty in an increasingly jumpy market, placing added impetus for Fitch's newly installed Recovery Ratings to help provide a better reflection of market sentiment. 'History tells us conclusively that this benign environment will not last forever,' said Managing Director John Olert.

Longer term implications of Fitch's Recovery Ratings also extend to the CLO arena, according to Group Managing Director John Schiavetta, who called the RRs, 'a positive development that will lead to changes in recovery rating estimates in Fitch's CLO modeling'. Schiavetta said an exposure report outlining the planned changes will be released by the agency by the end of June.

So while spread concerns persist, CLO growth is likely to continue, and in fact is already leading to more innovative structures, as discussed during a discussion panel moderated by Managing Director Jill Zelter. Panelists, including Managing Director Richard Hrvatin, said that the markets will see significantly more of permanent capital vehicles like master limited partnerships (MLPs) and off-shore vehicles in the CLO space, while market value CDOs and secured loan credit default swaps (CDS) become more mainstream and even synthetic CLOs begin to slowly emerge.

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