Junk Loan Shortage in Europe Sucks Diversity Out of CLO Deals

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If you bought a collateralized loan obligation in Europe recently, chances are you have exposure to John Malone’s Liberty Global Plc or Patrick Drahi’s Altice SA.

A shortage of new debt is encouraging arrangers to repackage portions of the same loans, increasing average overlap in CLOs to 38 percent, up from 30 percent last year and 28 percent in 2009, according to data compiled by Standard & Poor’s. That means that if one loan is downgraded or defaults more CLOs will be impacted.

“If a single borrower’s loans are held by a large portion of CLOs and it gets downgraded that could have a significant negative impact on valuations for the whole market,” said Tracy Chen, a Philadelphia-based money manager at Brandywine Global Investment Management, which oversees $67 billion of assets, including European asset-backed securities. “The high concentration is definitely negative for investors.”

New leveraged loan deals are off to the slowest start since 2012. At the same time, demand for CLOs is surging after European Central Bank President Mario Draghi excluded them from his asset purchase program, which has suppressed premiums in the rest of the region’s securitization market.

Europe’s CLO market is set for its highest full-year sales tally since 20.5 billion euros ($22.9 billion) was arranged in 2008, according to JPMorgan Chase & Co. Issuance of new debt totals 9.5 billion euros so far this year, according to data compiled by Bloomberg.

Loan Overlap

Of about 80 CLOs sold since 2013, loans made to Altice are held by 55 and loans to a unit of Liberty Global appear in 57, according data compiled by Morgan Stanley.

“Investors trying to build a varied portfolio of CLOs by buying an assortment of deals from different managers will end up with less diversity than one might expect,” said Conor O’Toole, Deutsche Bank AG’s head of European ABS research in London. “There’s only a finite number of loans in Europe which means the risks for investors are more concentrated.”

The overlap increases further when investors buy more than one CLO from the same manager, rising to an average 65 percent, according to S&P. Two transactions from Intermediate Capital Group had an overlap as high as 78 percent in May, Deutsche Bank analysts, wrote in a note to clients at the time.

Officials at ICG declined to comment on their CLOs.

Riskier Loans

“CLO investors should seek to understand the collateral manager’s risk-taking strategy and should be aware that in buying its CLOs they are taking exposure to the manager and its decisions,” said Srikanth Sankaran, head of European credit and asset-backed securities strategy at Morgan Stanley in London.

The lack of supply is also prompting CLO managers to choose riskier loans to securitize for better returns, according to Christos Danias, managing director of structured credit at Cantor Fitzgerald LP in London.

“These loans are riskier so if they are held by a lot of CLO managers we need to be wary of the situation in which they blow-up,” he said.

Sales of junk loans in Europe, at 73.1 billion euros, are down 23 percent from the same period of 2014, according to data compiled by Bloomberg.

Supply has dwindled as U.S. regulators increased scrutiny on leveraged loan underwriting practices, impacting deals on both sides of the Atlantic, according to Mike Kessler, a strategist at Barclays Plc in London.

“As the loan market has gotten smaller, issuer concentration has gotten worse,” Kessler said. “It will get better when we see growth in net loan supply.”