A collateralised loan obligation (CLO) is a tried-and-true technology when it comes to investing. It has endured the test of time and has shown impressive resilience – with stellar issuances even through the disruptions of COVID-19. CLOs became popular in the early 2000s, and they play a crucial role in the markets by providing financial institutions a means to securitise and transfer credit risk.
These complex structures can be sensitive to economic conditions and changes in credit markets. So, to explore the current climate of the European CLO market, we spoke with Arlene Allen, senior vice president and head of CLO Europe. Here are some of her expert insights based on what she’s seeing in the marketplace.
The CLO is a complex and highly sought-after financial instrument that represents a type of asset-backed securities. CLOs are typically created as a collection of loans – mainly syndicated loans together with some high yield bonds – which are pooled together and used as collateral to issue new securities. These new securities are then, in turn, sold to institutional investors.
Through the years, CLOs have evolved in different ways to adapt to market conditions and regulatory changes. CLO managers books have grown significantly over time, and the CLO product has delivered impressive yields to investors in varying market conditions. “Between 2008 and 2019,” according to Bloomberg Law, “the leveraged loan market – more than half of which is packaged into CLOs – increased from roughly $600 billion to $1.2 trillion.”
The growth of non-bank lending in Europe following the financial crisis has prompted managers to explore both regulated markets and debt capital markets (DCM) when looking to drive additional yield. Managers with success in the CLO space have also been successful in launching loan funds, thus generating investor appetite and opportunities in the loan funds and private credit space.
With this shift, CLOs as unregulated products have become incrementally more regulated. And in 2011, the European Securities and Markets Authority (ESMA) was introduced to enhance investor protection and promote stable and orderly financial markets.
CLOs are designed to take advantage of the arbitrage between their own funding costs and the rates on the underlying loans that they purchase and parcel up.
Recently, macroeconomic conditions like rising inflation, rising interest rates and geopolitical risk have been putting a squeeze on spreads. Narrowing spreads have significantly curbed CLO issuance in 2023 – particularly with sellers having difficulty finding buyers for the riskier equity tranches.
Larger CLO managers have been able to sell CLOs against this backdrop by leaning on captive equity vehicles (funds set up by managers to buy the equity tranches in their own CLOs). However, not all managers have these funds in place, which limits the number of CLOs that can be formed. Q4 2023 has seen a flurry of issuance on the back of slowing interest rates and inflationary pressures. However, in recent weeks, this window may have passed.
Leveraged buyout (LBO) and mergers & acquisitions (M&A) make up 50% of the CLO market. Activity in these sectors has also been off to a slow start this year due to the persistence of the same factors. Right now, they’re down 50% in terms of volume.
Capital adequacy requirements – for insurers under Solvency II and for banks under Basel IV – have created a more capital-intensive environment for sellers and clients in Europe, which has a ripple effect on liquidity. It causes higher hurdle rates, which in turn causes banks to step back from corporate lending, which in turn causes private credit lenders to step in and fill the gap and act as a direct competitor to banks.
Overall, numerous factors are affecting CLO issuance. This means that warehouses need to be more tightly managed, and that CLOs are taking longer to build. We saw some warehouses get terminated due to lending commitments expiring. But now, we’re starting to see issuances increasing and a few new warehouses opening. There have been a lot of positive signs and optimistic indicators – it’s just a matter of timing.
At U.S. Bank, we’re a major player in the CLO servicing space. As managers look to issue deals in Europe – and for many of them, doing so for the first time – we have a lot of experience, expertise and insight to offer. We have the data to help them make informed decisions. We have the flexibility to move quickly. And we have a broad range of resources and solutions to meet their specific business needs.
The market has been in a volatile state due, in large part, due to a regional banking crisis that came to a head earlier this year. New CLO issuance in Europe was less buoyant than in the U.S., where it was up 30% year-over-year by the end of Q1 2023. Europe was down approximately 30% year-over-year in Q1 2023, reaching 6.7 billion euros with a similar level of decline in April. However, “five European new transactions came to the market in August,” according to Fitch Ratings, “bringing a total of EUR 3.7 billion of issuance in 3Q 23.”
Institutional investors have continued to support new CLO formation through the first half of 2023. This is evidenced by the long-term track record of low CLO default rates across economic cycles. It’s also evidenced by the steady performance of CLOs relative to the wider investment grade debt market as interest rates moved upwards in 2022.
CLOs are designed to work through economic cycles. CLOs finance themselves by issuing floating rate notes, and the assets in which they invest have floating rates as well. This means that CLOs already in the market have been able to sail through the changing interest rate environment largely unaffected.
CLOs in reinvestment periods are especially well positioned. Reinvestment periods are timeframes agreed upon by investors during which CLOs can reinvest principal and interest proceeds generated from their underlying loan portfolios. CLOs within this window right now are benefiting from the opportunity to buy up discounted loans in the secondary loan market and boost returns.
Securing loans without this reinvestment advantage is prohibitively expensive at the moment, which is why so many managers are having a difficult time filling warehouses to issue new deals.
CLOs offer good credit and stand out in the structured-product universe on a relative value basis. While arbitrage is now particularly challenging – pricing and relative value can certainly change quickly, as we’ve seen over recent years – timing is everything.
When compared to vanilla corporate credit, CLOs still look very attractive. For similar credit risk, BBB corporates are typically paying less than half the income of equivalent BBB CLOs. While CLOs have always traded wide to investment-grade credit, the basis between vanilla credit and CLOs still looks wide.
European CLOs have been one of the best performing asset classes this year. And generally speaking, European asset-backed securities have outperformed vanilla credit over the last two years due to its lack of duration. We feel optimistic that the current supply-demand dynamic should help keep spreads stable.
After over a decade of zero interest rate policy, many business models don’t work with higher rates. Leveraged companies are most vulnerable to this due to their reduced cash flow post-rate hikes. Defaults have been at historic lows, however, it’s inevitable that this will increase with rising interest rates.
At U.S. Bank, we have the experience, reach and technology to navigate the mechanics of complex deals with transparency, consistency and unwavering quality. As new opportunities emerge in the European CLO landscape, we can help you understand some of the new legal and structural hurdles in this fast-paced market.