Record in Sight for Europe CLO Market After Loans RushBy
Better loan supply may boost CLO issuance in final months
14 new CLOs need to price to match last year’s total
The market for one of Europe’s more complex but vital asset classes may be on the cusp of another bonanza year.
The region’s supply of collateralized loan obligations -- debt securities made up of groups of leveraged loans -- is poised to jump from September, potentially boosting issuance beyond the record 16.8 billion euros ($19.6 billion) seen in 2016. A healthy pipeline is already building, while last month’s barrage of fresh loans should help banish the shortage of underlying assets that has plagued the industry this year.
That will be a relief to both managers and investors, who endured a first half dominated by endless loan refinancings and repricings that restricted the flow of new CLOs. Already the improved loan supply heading into the summer enabled manager OZ Management to price a 415.25 million euro transaction at the start of August, with Bain Capital Credit also adding to the month’s activity with a 363 million euro CLO.
Together these deals took CLO issuance to 11.2 billion euros so far this year, one billion euros ahead of the 10.1 billion euros priced by the same time in 2016, according to data compiled by Bloomberg. In the U.S. meanwhile year-to-date CLO issuance of $71.2 billion is twice as much as the $35.9 billion sold in the same period last year.
Back to Europe and based on previous market patterns, that means some 14 new transactions would be needed for a new record, or roughly three to four new CLOs per month.
That is, in theory, achievable, with 20-plus managers working toward their next new issue. Not all are planning to print this year leaving a question market as to whether the market reaches the upper end of the 15 billion to 20 billion euros of CLO issuance predicted by analysts in December.
Supportive conditions last year enabled arrangers to price 16 new CLOs totaling about 6.6 billion euros in the four months through December. The 8.4 billion euros of new loans launched by borrowers last month -- the most in any since July 2015 -- will help managers ramp their CLO warehouses, and an expected shift toward richer priced M&A-driven loans should also prove supportive.
CLO managers who have been busy with refinancing transactions this year may also refocus efforts on new issue as potential CLO refinancing candidates dwindle in the final months.
But quantity doesn’t equate with quality, and mangers say they remain selective even with the better loan supply. Weaker credit quality, borrower-friendly documentation or skinny pricing can all eliminate potential loan assets from a CLO portfolio.
Broader market conditions also play a part. As an example, having reached era lows in the low to mid-80s earlier in the year, liability spreads widened to 90 basis points in June. A move wider from here could pressure the arbitrage between the transactions’ income and funding costs.
The subsequent negative impact on equity returns could weaken the equity bid, making it harder for managers without captive equity to price deals, according to some market participants. "The market is bullish but the arbitrage is still challenged," Peter Keller, Citigroup’s co-head of European structured credit, said in an interview. "Managers with permanent capital in place via originator vehicles will have an advantage."
Conversely, any tightening of liability spreads could ease the so called "arb" and encourage supply, and even managers who syndicate their equity pieces may still be able to argue that even at 11%, CLO equity returns remain compelling in today’s low yield environment. Further, the opportunity to lock into rock bottom liability spreads in the promise of improved returns should loan pricing improve remains tempting.
So far this year loan pricing has moved in one direction -- lower -- although the better flow of loans to market means levels plateaued during the summer months. And with more higher priced M&A loan supply on its way loan pricing dynamics for investors could improve further.
Investor appetite is the other key ingredient for CLO formation, and after a busy year some in the market fear that fatigue could set in. On top of new issuance, CLO debt investors have invested in 18.4 billion euros of refinancings and resets so far in 2017, which is a huge amount even if refinancings target a different, short-dated investor base. That said, the slew of refis and resets should decrease in the coming months, freeing up demand for new issue.
Big-ticket Japanese investors may work to March year-ends, but others closer to home may run out of buying power as December approaches.
Whether this has an impact on appetite through year-end is debatable -- CLOs remain a popular investment prospect amid generally low yields, and high subscription levels and tighter liability spreads achieved on recent transactions prove that demand shows no sign of abating just yet.
(Sarah Husband is a leveraged-finance strategist who writes for Bloomberg. The observations she makes are her own and are not intended as investment advice.)
— With assistance by Ruth McGavin, and Azat Davletkhanov