Four Themes to Watch in European CLOs After Groundbreaking YearBy
Supply tipped by analysts to climb even further next year
Concern creeps in, replacing confidence among CLO managers
Over the coming year Europe’s collateralized loan obligation market will build on the themes that helped it smash through record after record in 2017.
New issue volume hit 20 billion euros ($23.7 billion) this year, the most since the market recovered from the financial crisis. Other records included era tight liability spreads and the largest post-crisis transaction, as well as the largest monthly issuance post-crisis. But while celebrating the year’s successes, pressure points are emerging and managers are concerned about how long overheated conditions in the credit market can last.
"I can’t see anything on the current horizon that will slow CLO issuance down, although there may be more challenges, including arbitrage and global economics going forward," said Jonathan Butler, head of European Leveraged Finance at PGIM Ltd in London. "Essentially we will see more of the same until something different happens."
1. Supply Surge
Supply in 2017 dwarfed any other pre-crisis annual volume as investors lapped up more richly priced CLO paper, relative to ABS and other assets classes. Add to this another 25 billion euros of refinancings and resets and it’s clear just how busy the market has been.
Momentum is expected to accelerate into next year and analysts across the banks forecast yet higher issuance. JPMorgan analysts expect 25 billion euros of European CLO supply while analysts at Citigroup predict between 22 billion and 26 billion euros of new CLOs. Morgan Stanley meanwhile puts 2018 new issue volume at 20 billion euros. This will see the market expand further increasing demand for loans even as the legacy market whittles down to zero.
Eager to take advantage of favorable dynamics, arrangers will likely try to get a head start on bustling pipelines in early January. Alongside the more familiar faces, U.S. issuers continue their CLO expansion plans; King Street Capital Management and Voya Investment Management are among those expected to follow this year’s debutants -- namely Onex Credit Partners, HPS Investment Partners and Brigade Capital -- into Europe in the coming 12 months.
2. Expanded Buyer Base
There’s little doubt about what has pushed Europe’s CLO market to its most successful post-crisis year: booming demand.
While better prospects for M&A-backed loan supply will also help issuance in 2018, it’s really Europe’s expanding buyer base, led by real money and structured credit hedge fund accounts, that will continue to fuel CLO formation and encourage managers to a market that’s as strong as it has ever been in the post-crisis era. And there’s no reason to believe this appetite will wane over the near term.
"Are these new investors here for the longer term?" asked Paul Tapper, managing director at NM Rothschild & Sons Ltd in London. "Some will be price sensitive, but if all asset classes move in tandem with each other then why would they move elsewhere if the asset class continues to perform?"
Increased competition for CLO paper pushed spreads across all rated CLO notes to post-crisis lows, except for the lowest, single-B rated tranche. Already at tights of 72 basis points, spreads on the highest rated debt tranche may cross into 60 basis points territory next year.
3. Refi/Reset Pipeline
Alongside a busy new issue schedule will be an equally busy refinancing and reset timetable as managers and their equity investors tackle the richly-priced early 2016 vintage CLOs. These priced at post-crisis wides and their high funding costs relative to repriced spreads on the underlying loan assets have impacted equity returns. Managers are also expected to take a second look at transactions that have already been refinanced to further reduce funding costs.
This follows the significant CLO refinancing and reset activity of 2017 as managers optimized their existing portfolios. Combined new issue and reset volume for the year surpassed the pre-crisis annual new issue supply peak of 33.3 billion euros set in 2006.
Even as managers protected returns by reducing funding costs across 2013, 2014 and 2015 vintage CLOs, the sustained loan repricing trend has taken its toll on CLO arbitrage. Recently measured internal rates of return (IRRs) on CLO 2.0s are below levels from last year, according to a Citigroup research note, and some equity investors are reassessing the asset class given concern that the market is further along in the credit cycle.
Other investors remain comfortable with the risk-reward profile, especially relative to what is available elsewhere, and demand for CLO equity remains solid right now, said CLO arrangers. Median 2.0 equity IRRs at 14 percent compares favorably with private equity, wrote the Citigroup analysts.
4. Notes of Anxiety
It won’t all be about superlatives next year, however, as anxiety replaces some of the confidence evident among CLO managers a year ago.
The current credit environment, the attrition of spreads, the late-in-market cycle are combined a cause for concern in this discombobulated market, according to one London-based CLO manager, echoing the views of others.
Some managers have taken reassurance from the strong macro environment, low default rates and the general good health of their portfolios. This is despite the idiosyncratic risks from credits including New Look Retail Group Ltd, Deoleo SA, Flint Group, Altice NV and Concordia International Corp.
"I don’t think we are at the top of the market yet; the Eurozone is gaining momentum at the moment, but we are earlier in the cycle than in the U.S." PGIM’s Butler said. "Quantitative easing is still ongoing, although reducing, and the global growth outlook appears to be increasing while the default outlook is also benign for now."
Managing CLOs has also become tougher in other ways. In a loan market awash with liquidity CLO managers in 2017 have had to fight for assets to ramp transactions, and have found themselves unable to participate in the stream of repriced and refinanced loans that are either too tightly priced, too long in duration or simply too risky to suit CLO portfolios.
As loan repricings turned up the pressure on CLO collateral quality tests during the year, managers were forced to reset these tests and matrices to release the tension.
Even so, ratings agencies paint a supportive picture for Europe’s CLOs in the coming year. "Existing deal performance will remain strong in 2018 amid a stable macroeconomic environment in which all of CLOs’ largest sector exposures have stable outlooks," said analysts at Moody’s Investors Service in their 2018 outlook.
(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 Alejandro Sicilia Cruz