Analysis: Banks’ waiver of junk-rated loan funds worsens funding freeze

NEW YORK, July 19 (Reuters) – Banks’ decision to change how they invest excess capital is limiting their ability to lend to companies with weak balance sheets during the financial market downturn, fund managers said and investors.

Banks offer subprime loans to companies with limited cash flow when they are convinced they can sell them to investors in order to recycle capital.

The main buyers are secured loan obligations (CLOs), funds that have struggled to raise capital lately due to a pullout by one of their biggest investors – banks.

Banks have traditionally acquired highly rated bonds from CLOs, which use the proceeds from the sale to buy risky or leveraged loans from banks.

Banking demand has cooled in recent months as higher interest rates have made bond yields less attractive than higher-rated assets such as U.S. Treasury securities and mortgage-backed bonds, analysts said. market sources. This weighs on new CLO offerings.

The bottleneck occurred as central banks rapidly raised interest rates to fight inflation, leading banks to cut lending to companies with weak balance sheets. The impact extends widely across the financial system, investors and bankers said.

“Major buyers of investment-grade CLO liabilities have been impacted by interest rate fluctuations and volatility in global financial markets, reducing their ability to make new investments in CLO debt,” said Doug Paolillo, head of the CLO business of investment firm Sixth Street Partners.

Banks are also struggling to sell leveraged loans because buyers are looking for more favorable terms. Many of the loans the banks are selling were priced before Russia’s invasion of Ukraine and the rapid central bank rate hikes that fueled concerns about an economic slowdown. Read more

CLOs, which account for about two-thirds of leveraged loan demand, are also struggling to raise capital. CLO issuance fell to $72 billion in the United States in the first half of 2022, down about 11% from the previous year’s record high of $81 billion, according to data from the data provider. Financial Refinitiv.

As a result, leveraged loans in the United States fell 31% to $479 billion in the first half, from $692 billion in the same period last year, according to Refinitiv.

“There has definitely been a pullback in triple-A CLO (bond) buyers in the market compared to 2021,” said Lauren Basmadjian, head of U.S. lending and structured credit at private equity firm Carlyle Group Inc ( CG.O).

IMPACT ON LEVERAGED BUYOUTS

Many private equity firms rely heavily on leveraged loans, as their investment strategy is to indebt companies to the point that they are rated as junk. The slowdown in leveraged lending has limited their ability to close deals.

Private equity-backed mergers and acquisitions fell 42% to $352 billion in the first half of 2022 in the United States, from $604 billion a year ago, according to data provider Dealogic.

CLO managers try to win back banks and other investors with higher interest rates. The average coupon on senior CLO bonds fell from the guaranteed overnight funding rate (SOFR) – the benchmark interest rate used by most banks – plus 134.6 basis points in January to SOFR at 184.3 basis points in June, according to Refinitiv.

But higher rates have not been enough to attract as many investors as last year, and CLO managers are reluctant to offer even higher coupons that reduce their profits.

“If I have to pay a higher rate on the triple A (CLO bonds) I issue, then I’m going to charge a higher rate on the assets I buy that are below investment grade,” he said. said Clayton Perry, head of structured credit at private equity firm KKR & Co Inc (KKR.N), which has a CLO business.

Reporting by Chibuike Oguh in New York; Editing by Greg Roumeliotis and Richard Chang

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