It is easy to get carried away with the euphoria surrounding the nascent resurgence of the CLO market in Europe. However, the three CLOs that have been priced so far this year have provided only €1bn of funding. And if the most optimistic hopes of a further handful of deals actually materialises, total issuance will only just make it to €3bn.
As much as this should be applauded, it’s hardly going to be enough to prevent a large net contraction in credit. That’s because there is about €70bn of outstanding pre-crisis CLOs that are close to ending, or have already reached the end of their reinvestment cycles.
This doesn’t mean that €70bn will leave the CLO market on January 1 2014. It means managers will be obliged to use any money that comes into the vehicle to repay CLO bond investors, as opposed to replenishing the deals with more leveraged loans.
But it does mean that, unless the CLO market returns to its full pre-crisis vigour, or unless the high yield bond market takes up all the slack, that portion of the credit that was funded by CLOs will slowly be replaced by more expensive and less efficient funding. Or possibly none at all.
This is a shame, given that CLOs have performed exactly as they were supposed to. The effort to make the financial world a safer place has burdened the CLO market with stricter rules, in particular the regulations that govern risk retention under Article 122a of Basel III’s capital requirement directive.
This regulation will mean that undertaking an investment in the first loss equity portion is now a much more onerous obligation than it was. And without the lynchpin of equity investment there can be no CLOs.
Even for investors of rated CLO debt it is questionable whether the new breed of structures will actually make the product any safer. In fact, it is entirely possible that tough CRD rules may indirectly contribute to CLOs becoming a worse investment.