Collateral correction?

In the second quarter, the new-­issue market for structured finance vehicles that buy leveraged loans -- collateralized loan obligations, or CLOs -- enjoyed a minirevival as eight managers inked $4.2 billion of new deals. That's the highest figure since the third quarter of 2008, and it lifts the year-to-date total to $5.3 billion, above 2010's full-year sum of $4.1 billion.

There is more to this jump than meets the eye, managers say, because the 2011 collateralized loan obligation class represents new-money deals, as opposed to the refinancing and portfolio trades that dominated last year's action.

June's quartet of new collateralized loan obligation deals -- from managers LCM Asset Management LLC, Apollo Credit Management LLC, Carlyle Group and Blackstone Group LP's GSO Capital Partners -- demonstrate why the CLO trade has gained traction over the past three months: Expanded leverage and tighter AAA-rated senior liability clearing spreads have boosted prospective returns for equity investors.

Start with leverage. The rebirth of the market for mezzanine CLO paper has enabled collateral managers to shave equity contributions to 10%, on average, for the eight most recent deals, from 12% earlier in the year and 15.7% on fourth-quarter deals.

Also helping arbitrage is tighter clearing spreads for AAA tranches, which sources say have benefited from strong demand from Japanese banks and insurance companies as well as some American institutional investors. Thus LCM and Apollo printed their senior-most liabilities of June's deals printed at discounted margins of L+120-124, respectively, inside the prior low-water mark of L+125 from May and ­L+175-200 earlier in the year. Finally, the CLO market has benefited from a surge in new-issue loan volume. In May, institutional loan volume excluding repricings -- which are syndicated anew but obviously don't contribute to available supply -- jumped to a post-Lehman-bankruptcy high of $25 billion.

All of this new collateral -- which cleared at an average spread of L+525, including the LIBOR floor benefit -- has given managers a ready source of paper from which to ramp new deals, and at wider spreads.

What's more, May's new-issue glut, along with the recent drumbeat of dour economic reports, has combined to push secondary prices lower and new-issue yields higher. For these reasons, managers say, prospective collateralized loan obligation equity returns have climbed into the mid- to high teens, from 8%-10% previously. It follows that the two most recent deals were upsized from initial talk: LCM by 63%, from $410 million, and Apollo by 12%, also from $410 million.

In addition to better potential deal economics, dealers have helped grease the new-issue skids by making warehousing lines available at more transaction-friendly terms. Though each line is highly negotiated -- with terms varying widely based on the dealer, the manager, line amount and the triggers -- managers say these are, broadly speaking, the terms on offer today: (1) spread of 100-125 basis points over LIBOR; (2) first-loss provided by the manager or the lead investor of 15%-25%; and (3) a ramp-up period of six to 18 months, with mark-to-market triggers.

Though these terms are nowhere near the go-go levels of the boom (what is?), the mere fact that warehouses are again in play has helped boost activity by enabling managers to develop portfolios of largely new-issue paper rather than relying more heavily on the secondary market, where prices are typically richer.

As a result of all these salutary trends, managers expect to see $1 billion to $2 billion a month of new collateralized loan obligation issuance during the second half, in line with the consensus forecast of $10 billion to $15 billion for total 2011 CLO volume from such market experts as David Preston of Wells Fargo & Co., Justin Pauley of Royal Bank of Scotland Group plc, Rishad Ahluwalia at J.P. Morgan Chase & Co. and Vishwanath Tirupattur of Morgan Stanley.

Before we get too carried away, managers note that raising a CLO is still no mean feat.

Noncaptive equity remains scarce, and mezzanine liabilities are pricing at wide levels. That means that CLOs are still -- for the time being, anyway -- the province of large managers that have strong equity-raising capabilities and the wherewithal to ramp up deals. Not for nothing are boutiques still largely on the sidelines. The list of managers that have raised a CLO this year is composed of large complexes, many of which are affiliated with private equity firms.

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Steven Miller manages Standard & Poor's Leveraged Commentary & Data business.