European ABS and CLO markets ready to roll but rocky road lies ahead
European ABS market participants are optimistic about 2024, despite the persistence of rates volatility and economic fears. While poor arbitrage haunts the CLO market, managers are ready to tighten the straps on their captive equity funds and soldier on. George Smith and Victoria Thiele assess the market outlook for European securitized products
Just as it did when it was looking ahead to the new year 12 months ago, the European securitization market has its eyes on central bank policy — and economic pressures.
In 2023, central bank interest rate increases — from both the Bank of England and the ECB — materialised as threatened, but a broadly predicted recession did not. And although inflation continued to squeeze consumers, securitization collateral performance was better than many expected, across asset classes.
Looking ahead, the question is whether the market is able to again withstand these two major headwinds. Underlying loan performance will once again be high on securitization investors’ agendas in 2024, as the consensus is that the full impact of rate rises has not yet fed through.
“In most cases, performance isn’t even back [down] to where it was pre-Covid,” says Doug Charleston, portfolio manager at TwentyFour Asset Management. “People forget that post-Covid performance improved materially, and more people repaid debt. We are still reversing out of that and it will go beyond that in 2024, but we still feel pretty healthy.”
The silver lining is that much of the market believes interest rates have hit their peak already. In GlobalCapital’s survey of European securitization market participants, only 18% of respondents predicted any further rate rises at all. And no one forecast more sharp rises in 2024.
What will happen to interest rates during 2024?
Central bank policy tightening has already delivered a jolt of life to the securitization market, as the winding down of long-term funding schemes increased issuance volumes.
The Bank of England’s Term Funding Scheme with additional incentives for SMEs (TFSME) is rolling off after drawdowns closed in late 2021, while banks have been repaying slugs of the ECB’s Targeted Longer-Term Refinancing Operations (TLTRO).
Banks looking to replace that funding — or simply to diversify their options — have been turning to securitization.
Indeed, placed issuance volume in 2023 will come in higher than it did in 2022, exceeding previous expectations.
Charleston says that, in part, this was because of returning banks.
“When the banks do come back, they do big transactions,” he says. “It moves the needle quite significantly. We would expect a continuation of that.”
UK prime RMBS is the market most obviously benefiting from the return of banks. Lloyds revived its Permanent shelf in May 2023 after a hiatus that had stretched back to 2019. It initially priced a blockbuster £1bn deal at a spread that came inside covered bonds, and a second £750m Permanent deal followed just two months later.
Leeds Building Society also returned to the market for the first time since 2019, and overall volumes of placed prime UK RMBS are back to up to pre-TFSME levels.
Prime UK RMBS issuance timeline
Timeline showing issuance from a selection of prime UK RMBS shelves (deal size in millions)
The area of each circle is proportional to the deal amount expressed in GBP using the exchange rate £1 = $1.25.
Bank issuance has also risen in other markets. Tesco Bank brought two sterling credit card ABS deals from its Delamare shelf, the first since 2020.
In euros, the auto ABS market, too, benefited from increased bank activity. DBRS put issuance up by 43% year-on-year as of the end of the third quarter. Both Santander and Crédit Agricole have been particularly active across asset classes, ranging from consumer loans to an equipment leasing deal from the French lender.
However, large-scale euro prime RMBS remains a missing piece in bank issuance. There has been a small pick-up in activity, but nothing on the scale some had hoped for.
Dutch prime has grown year on year, but there were still only four deals as of mid-November. There has also been more activity in Irish RMBS, and BPCE’s €900m French deal in October was a particular positive for the market.
No game changer
Indeed, securitization issuance is still facing difficulties.
For a start, higher rates have made mortgage originations harder for lenders. In the UK, the second quarter of 2023 brought the largest quarterly decrease in outstanding mortgage values, based on data going back to at least 2007.
The lack of collateral is dragging down non-prime RMBS issuance, which was already subdued because of the lack of big refinancings this year.
Regardless, survey respondents predicted issuance to grow further in 2024.
How much higher will non-retained public issuance volumes in European ABS (excluding CLOs) be in 2024 than in 2023?
In the somewhat revived CMBS market, survey participants also expect activity to rebound. Blackstone priced two logistics deals in July and October, the first CMBS since May 2022.
A report from ratings agency KBRA identified 13 European CMBS deals with maturities in 2024. Refinancing rates are levelling off, while valuations are stabilising. This points to the possibility of more deals in 2024, according to the rating agency’s researchers.
“There have been a few [CMBS] transactions, and secondary market activity is starting to pick up,” Charleston says. “I wouldn’t say I am expecting a resurgence, but CRE transactions could start to take off.”
How many CMBS deals do you expect in 2024?
Synthetic significant risk transfer has been the bright light of securitization growth in Europe. According to some estimates, the market has grown fivefold since 2010 by deal volume and eightfold by number of active banks.
In 2023, the market expanded across Europe. Croatia boasted its first ever deal in January, with Raiffeisen and the EBRD teaming up, while in September mBank and Christofferson Robb & Company pulled off the biggest ever SRT trade in CEE.
GlobalCapital’s survey suggests that SRT will again be important for managing bank capital: more than 90% of survey respondents expected the market would continue to grow.
Tightening despite ECB exit
Despite the worries over collateral performance, most survey respondents say they believe spreads will not lose ground in 2024.
After a period of tightening at the start of the year, some were surprised by how stable spreads had remained in 2023, in the wake of the volatility of 2022. Only at the end of the year have benchmark German autos lost any ground.
Still, all triple-A rated tranches from Mercedes, Volkswagen and BMW were priced between 40bp and 50bp, and in 2024 they could edge back towards the lower end of that range. The final deal of 2022, from VW, had been priced at 55bp.
Reoffer spreads on triple-A rated auto ABS tranches from BMW, Mercedes and VW
Given that issuance is expected to rise, and if the prediction of tighter spreads is to come good, then a simple supply and demand analysis would suggest that investors need more funds. On that front, Charleston is optimistic.
“ABS is having pretty much the best performance in fixed income in 2023,” he says. “If you are a big fund with 5% allocation in ABS, you are unlikely to be reducing that and if anything you have probably explored increasing it.”
Will European ABS spreads be wider or tighter at the end of 2024 than at the end of 2023?
Overall, survey participants predict issuance to increase, spreads to tighten, and more cash to flow into the market. After a 2023 of surprising stability, the European ABS market is entering 2024 in an upbeat mood.
CLOs battle through
There is also optimism in European CLOs, where issuance volumes have exceeded even the most optimistic forecasts this year.
As of November 10, some €23.9bn of deals had been priced in Europe. At least another €1.5bn worth of transactions were in the market — even though poor arbitrage between assets and liabilities made buying CLO equity tranches unattractive for most of the year. Managers who were able to take their own equity, usually through risk retention funds, kept the market alive.
For 2024, 45% of survey participants predict more issuance than in 2023, while 32% expect stable levels of activity — though not necessarily for the right reasons.
“We are going to see a healthy amount of issuance,” says Pim van Schie, senior portfolio manager at Neuberger Berman, “but not necessarily driven by arbitrage.”
Almost 84% say that third party equity investors will not return to the CLO market in significant scale before the second half of 2024. And more than a third believe that it will not happen in 2024 at all. Yet big global funds with a CLO platform still have plenty of risk retention money on the sidelines, van Schie says.
“As soon as you see some spread tightening on CLO triple-As, that will bring out more people with new deals, which may still be funded by captive equity,” van Schie says. “That could prolong further the environment of unattractive arbitrage, and may keep third party equity investors out of the market for longer.”
Do you expect CLO issuance to be higher or lower in 2024 than in 2023?
When do you expect third party equity to return to CLOs to a meaningful extent?
However, some question how long CLO issuance can be sustainable if managers keep buying unattractive tranches through captive equity vehicles.
“I don’t think that issuance can grow materially without third party equity coming back online,” says Ronnie Jaber, co-head of Onex Credit.
Issuance levels are a function of European credit activity, Jaber adds.
“We believe M&A activity will increase from low levels, driving more loan issuance,” he says.
This should push prices down in the secondary loan market. If loans become cheaper, CLO equity starts to look more compelling, meaning that third party investors could indeed come back to the market in 2024 — just not for every manager.
“I think there will be further manager tiering,” Jaber says. “Some managers with riskier portfolios and higher default rates may not see third party equity for extended periods.
“Then there are managers who have done a good job, and investors will want to buy equity — and debt — from managers who protect their principal.”
Across the capital structure, survey participants say they expect the number of CLO investors to remain stable or increase slightly.
Many in the market hope that US banks will return to the European CLO market early next year as regulatory hurdles are removed. This could represent “a strong bid” for triple-A tranches, says Jihan Saeed, head of structured credit at Permira. “That should give managers the confidence to continue to at least open and ramp warehouses.”
Private credit CLOs
Direct lending is booming in Europe. Every CLO conference that GlobalCapital attended in 2023 dedicated a panel — and a good portion of lunchtime gossip — to the question of when and how middle market or private credit CLO issuance could evolve. In GlobalCapital’s survey, market participants were undecided on whether Europe would see its first private credit CLO next year, although those brave enough to commit to an answer leaned towards “yes”.
Do you expect to see the first private credit CLO in Europe in 2024?
“If you are a big firm, with a direct lending business and have issued BSL [broadly syndicated loans] CLOs before, it makes sense to test the market,” says Jaber at Onex. “I suspect we will see the first European private credit CLOs in the first half of next year.”
Rating a middle market CLO will be more difficult in Europe than the US because of stricter requirements, and some market participants have pointed out that debt investors may demand a bigger equity buffer for their protection on such a deal, which could make the arbitrage even more unattractive than on regular CLOs composed of loans syndicated by banks.
However, “in the US, in our experience the arb for some types of private credit CLOs has been better than for broadly syndicated CLOs for much of 2023,” according to van Schie. “In these cases, the benefits of the yield on the portfolio outweigh the additional cost of debt.”
Van Schie adds that opening a private credit CLO market would be a smaller step in Europe than it has been in the US.
“Ironically, in a way, European CLOs — when compared with the US — are already somewhat more private credit-like because the collateral is much less liquid, and so is the market for CLO liabilities,” he says.
Perhaps the most surprising results of the survey stem from the question of how the number of CLO managers will develop next year: 48% of respondents expect it to remain at its current level, while 32% said it would increase. Only 19% said they expect a reduction.
Consolidation among European CLO managers often appears to be just on the horizon. Many in the market agree that 65 managers competing over a limited number of leveraged loans in Europe is simply too many. Although a few new managers priced debut deals in 2023, including Signal, Pemberton and Arini, there are compelling reasons why more mergers could happen in 2024 year. Only about two-thirds of the European managers printed deals this year. Smaller houses, in particular those without captive equity, struggled to issue.
“We have been a bit surprised by how many new managers are still entering the market,” van Schie says. “I would guess, on balance, that we are going to see more consolidation than new managers.”
Talking to GlobalCapital, most of his peers echoed the sentiment.
Going into 2024, the overarching sense in the market is not quite optimism — but not quite despair.
Defaults and downgrades are expected to increase slightly, but not devastatingly. Leveraged buyouts should pick up somewhat and provide some relief to the CLO arbitrage, but captive equity will remain important in execution. CLO managers prepare to battle on, boats against the current — and the bigger they are, the better they will float.