Europe’s Expanding CLO Market to Build on Record Year in 2017by
2017 issuance should exceed 2016’s record on hunt for yield
Headwinds include collateral supply, regulation, macro shocks
Issuance of CLOs in Europe in 2017 may exceed this year’s record for post-crisis sales with a well-stocked pipeline of new deals, no let-up in investor demand and supportive credit conditions.
Themes seen in recent months look set to carry over into next year, with the issuer and investor base diversifying, more CLO refinancings and resets, further contractions in CLO liability spreads, and managers with stronger track records getting better pricing. In 2016 CLO sales totaled 16.81 billion euros, according to data compiled by Bloomberg, about 3 billion euros more than last year, and a record volume in the post-crisis era.
“The outlook for CLOs looks good next year, as the global hunt for yield continues and the overall macro backdrop is supportive for credit,” said Jonathan Butler, Head of European Leveraged Finance at PGIM Fixed Income. "We should see the loan market grow as sponsors opt for loans over bonds, while we don’t see that defaults will pick up markedly next year. On the CLO investor side, we are seeing some of the best CLO 2.0 conditions for CLO issuing CLOs, with new investors finding equity attractive and CLO liability spreads tightening."
Forecasts from bank analysts suggest issuance next year may be at least as much as this year, if not higher. Dominik Winnicki, credit strategist at Barclays Bank Plc, expects a total of 15 to 20 billion euros, while analysts at JPMorgan Chase & Co. and Morgan Stanley predict roughly 20 billion euros. Citigroup Inc. analysts see 15-19 billion euros of supply.
Issuance in 2016 started slowly amid the volatility at the start of the year and sales improved from April and accelerated after the Brexit referendum. In all, 29 issuers tapped the market with 40 transactions, the data show. GSO/Blackstone and PGIM both issued three CLOs this year and seven managers issued two. Last year’s issuance came from 34 transactions and 24 managers, with three managers printing three transactions, and four managers printing two, the data show.
There were fewer debutants in the market this year than last, with just four -- BlackRock, BlueMountain, Accunia and Och-Ziff -- compared with nine in 2015.
CLO issuance this year has been shaped by an abundance of liquidity, from both CLO investors and across the broader markets. The ECB’s accommodative policies helped make spreads on CLO debt attractive relative to other asset classes amid the wider hunt for yield.
The CLO investor base diversified and expanded and included Japanese banks able to hoover up entire AAA-rated tranches. Demand from European accounts stepped up too with asset managers accounting for roughly 15 per cent of European AAA (1.0, 2.0 and recent 2.0 refis) buyers, according to data compiled by Citi. Banks represent roughly 44% of AAA buyers, insurance companies 35% with pension funds and family offices making up the rest, the data show.
Increased competition for assets helped tighten spreads at the top of the CLO stack inside 100 basis points, with the most senior tranches ending the year at about 95-100 basis points from 145-150 basis points in January.
It’s been a different story for CLO mezzanine spreads, starting the year around mid-800 basis points and then ballooning out during the volatile first quarter to above 1,000 basis points, at least for some transactions. Despite some tightening over the summer, spreads have widened again during the final months. With such yields, buyers may be tempted by the attractive margin relative other credit opportunities.
"The gap between CLO double-Bs and loans looks wide compared to history, and with more tightening in loan spreads, double-Bs should benefit," said Ratul Roy, securitized product strategist at Citi in a Dec. 15 research note.
At the bottom of the stack, the CLO equity investor base has also expanded since the summer, as contracting liability spreads have boosted the potential returns available. Equity investors are also benefiting from the recent CLO refinancing trend as issuers reprice liability spreads tighter, helping the CLO arbitrage.
To date, seven European CLO refis and three CLO resets have priced, and the trend is set to continue into 2017, assuming the buyer base for refi paper can accommodate the volume. Managers of early 2015 CLOs, still in their non-call periods and so unable to counter the collateral repricings via a refinancing, will be eager to get to work on these transactions as they become callable next year.
As the investor base has diversified, so too have structures. As spreads on single B notes gapped out, these expensive tranches were stripped from structures. At least seven CLOs priced this year without single B tranches.
Risk retention is a focus in the CLO market, and after the Brexit vote Europe’s CLO managers switched from to manager originator from sponsor structures. Since then, managers of 15 of the 23 new CLOs have opted for the originator structure for risk-retention compliance, data compiled by Bloomberg show. This reversed the first half’s trend, when 13 of the 18 CLOs issued prior to June 23 used a sponsor structure, according to data compiled by Bloomberg.
Meanwhile, ahead of the U.S. retention deadline on Dec. 24, two managers, CSAM and PGIM, became the first European managers to issue dual-compliant transactions.
Regulation, collateral supply and macro shocks, which have threatened to dampen supply for several years, remain potential risks. Particularly in the second half of the year, the market has taken macro events in its stride, helped by the ECB. Potential disrupting events include Trump’s presidency, the triggering of Article 50 for Brexit, elections in France and Germany, and diverging interest rate policy around the globe.
From a regulatory viewpoint, U.S. risk retention regulation becomes effective in just over a week, but much focus will be on whether the new president will seek to relax retention rules and whether this will trigger a surge in issuance. Europe has its own regulatory issues to focus on and next year’s ’trilogue’ negotiations over the EU’s securitization regulation will share the spotlight with Brexit.
An end to the repricing trend in leveraged loans would be the holiday gift many investors might like, particularly after falling loan pricing dominated issuance during the second half of 2016, threatening CLO arbitrage. More LBO supply might help take the heat out of the market, and there are indications the first quarter will be relatively busy. With CLO issuance set to continue, so too will loan borrowers want to tap into ongoing demand.