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The old with the new: plotting the course for European CLOs

The European CLO market has reached a juncture. The asset class has performed well over the past two years, with spreads ratcheting to post-crisis tights while a broader range of investors from across the globe have been drawn to the sector.

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The market has also been fluid in the way it has dealt with new regulation, an approach that will be crucial in coming months as it faces potential changes to risk retention rules, as well as new questions over the market’s future in light of Britain’s vote to leave the European Union. 

CLO managers have been able to navigate an extended benign credit environment with skill, and the industry is humming along well. But with a hot leveraged loan market causing some concern, lingering questions must be addressed if European CLOs are to continue their bull run. 

GlobalCapital assembled a panel of experts in London to discuss the state of the market and the questions that need answering to ensure its continued success in 2017 and beyond. 

Participants in the roundtable were:

David Nochimowski, global CLO strategist, BNP Paribas

Ian Perrin, associate managing director, Moody’s Investors Service

Robert Reynolds, CIO, Spire Partners

David Bell, moderator, GlobalCapital


GlobalCapital: Risk retention is still the biggest question mark for Europe’s CLO market. How are managers approaching issues such as Brexit and potential increases to risk retention levels? How does the market move forward from here? 

David Nochimowski, BNP Paribas: Risk retention is still a big question both in Europe and in the US. I don’t think there is one single solution that is the most optimal one. If you look at the deals that were done this year so far in Europe, I think it’s probably 50/50 between the sponsor route and the originator route.

In 2015, the sponsor route was popular as the originator route was being tested by regulators. And then in 2016, after the Brexit vote, the originator route became the more favoured one because the MiFID authorisation of UK-based sponsor managers became a question mark. 

But what was interesting is that the pricing, at least in the secondary market, hasn’t really differentiated between the sponsor route and the originator route. It did differentiate in the first two weeks after the vote on Brexit, but since then we haven’t see a real pricing differentiation. It seems that every manager has its own strategy, so there’s no optimal solution. 

The vertical approach is now becoming more popular. This year I think around 60% of managers have used a vertical slice approach versus horizontal slice. One of the reasons is probably easier access to funding. This could be positive for investors that want to participate in the equity, as it leaves more share of equity to invest in. 

The vertical slice could also be an optimal way to achieve dual compliance, as its definition is pretty much similar between US rules and European rules. 

Rob Reynolds, Spire Partners: Risk retention is a concept borrowed from the insurance industry and dates back to the 1970s when it wasn’t possible to get product liability insurance. The idea broadened out to what we know today as the insurance excess where the insured party retains some of the risk and gets a lower premium. Retaining some risk meant that people were also more protective of their assets. 

Risk retention for securitization was introduced after the subprime crisis. One of the issues was the agency model in which the originator of the mortgages passed on all the risk to third parties.

Thus the idea was to align the interests of the investors and the originators and managers. In fact, CLOs worked well before and through the crisis, so I don’t think risk retention was necessary for the CLO model to work, but it did give the regulators comfort that the agency model had been addressed. 

In our experience, investors are not seeking an increase in the risk retention amount. It’s not an investor requirement so the optimal level is really a question of the balance between what managers can fund, what investors require and what regulators consider appropriate. 

Ian Perrin, Moody’s: What I found interesting with the risk retention is just how the CLO managers’ community has been nimble about it since its inception. As David has pointed out, you started by having the horizontal slice then there was a switch to vertical as funding solutions came along. It’s a topic that’s been constantly moving with the approach taken by the regulator. 

With Brexit, there are people already going to the originator route. Whatever happens, the CLO managers’ community seem to adapt to what’s put on the table, and hopefully the market will continue. A potential increase of the 5% retention level is going to be punitive to the market, but you would expect that the market will find a solution. 

Reynolds, Spire: I would add that CLO structures changed post crisis. Initially, the deals were less levered, for example, but also there was more control put on the eligibility criteria and the percentage buckets, et cetera. So there was an evolution, as well, within the CLO market separate from the introduction of risk retention. 

GlobalCapital: David, you mentioned appetite from investors on financing risk retention. Are you seeing a lot more appetite from investors who want to finance that? 

Nochimowski, BNPP: Yes, I think it’s a new development. With risk retention rules being effective both in the US and Europe, it creates new market opportunities. But in order to be able to finance risk retention, you need to be able to provide long-term financing. In Europe, you have to keep the retention for the entire life of the deal. In the US, it could be a shorter period, but it’s still a relatively long period. 

So you might see some more long-term investors, such as insurance companies coming into this market, and some banks could also be able to provide funding solutions. Given the tenor and given the requirements, it offers new opportunities for funding providers. In Europe, there are not as many deals as in the US, so have to see still how this develops, but we should expect these opportunities to be mostly focused on vertical slice options. 

I think retention financing will become critical, and this is probably where the future growth of this market lies. If some institutions have the ability to provide this long term financing, it opens doors to further business expansion.

GlobalCapital: Bringing insurance companies back into the market, this is something that the market’s been crying out for, hasn’t it — the return of long-term insurance capital? 

Nochimowski, BNPP: True. I think the European market has suffered, over the last few years, from the lack of insurance money investing in CLOs. I’m referring to European insurance companies not investing in the CLO capital structure due to the relatively expensive cost of Solvency II capital.

That has created some weakness in the mezzanine part of the capital structure, which other investors have filled. It is regrettable as you have a stable investor base in Europe, which is not being fully exploited. So we have to see the extent of their participation to this market by providing retention financing. I think that could help solve an important part of the equation.

: From a regulatory perspective, do the same disincentives not apply to insurance companies financing risk retention? 

Nochimowski, BNPP: Well, that’s a good question, whether investing or providing financing would be treated the same way. European insurance companies have probably done much work on that, but anything that helps them to come into this market is very positive, for the stability and development of the CLO market, which is needed for the European economy.

GlobalCapital: Do you see that appetite coming back, as well, Robert? 

Reynolds, Spire: There is constant debate about risk retention financing, that’s for sure. Could we cope with an increase in risk retention requirements as a market? Yes, I think we could. But then it’s a question of choice. Is there a better use for that capital, are there different structures available? As I said before, we’re not seeing requests from investors for an increase in the risk retention amount. It’s not high on the agenda, it’s actually not a topic we discuss with them, so it’s not coming from the investor side.

GlobalCapital: It seems as though, over the last year, that the investor base for CLOs has broadened and we’ve got a bigger range geographically and institutionally of investors buying into CLO debt. Do you get the sense that CLOs are becoming less niche, less of a specialist investment and they’re becoming a more broadly appreciated asset class? 

Nochimowski, BNPP: I think it’s still a niche product. To be clear, from a regulatory standpoint it’s still considered a structured product and it’s not changing. Just looking at the spread levels, it’s wider than many comparable products in the market, so that’s evidence that it’s still not completely viewed as a flow product. 

But you’re right, there’s been some development over last year in the European CLO market. I think the major development has been the interest of Japanese investors on the triple-A part of the capital structure. If you just look at the spread on triple-As, it has moved in by more than 50bp over last year, and this is really the evidence of the participation of Japanese investors. This is important, because they represent a stable investor base which is looking more at a buy and hold to maturity approach, in the same way they invested in US CLOs. At the top of the capital structure, there is very good demand and this Japanese bid is helping. If you look at the bottom of the capital structure, equity and junior debt, then you see more the presence hedge funds investors 

This base is less stable, because of course, by nature, these investors are looking at the secondary market to benchmark performance. So I think we have to differentiate really between these two parts of the capital structure: senior versus subordinate.

Perrin, Moody’s: One thing that has helped is the performance of the CLO product. I think the CLO 1.0 product, having gone through the crisis, has come out of the crisis pretty strong. The CLO has been a really great example of a securitization and how it actually works. You have OC triggers that have been breached, diversions of interest flows that have helped redeem the senior notes. You have managers that have been able to purchase assets at a discount and rebuild par, and I think you’ve seen a lot of transactions going through difficult times in 2009, 2010, 2011 and really coming out of that pretty strongly. 

I think we see the flow of transactions being redeemed on that side, and the losses really have been limited at the most junior part of the capital structure — less than five or six transactions have suffered losses on junior tranches, with probably another handful on the remaining stock of 1.0. I think investors have seen this strong performance and that’s helping them return to the market. 

Reynolds, Spire: I like to see new investors, I like to see new managers, and I like to see the market grow as a whole. To pick up Ian’s point, CLOs now have a 20-year track record through the cycle, and actually, as David mentioned, it’s back on a growth path. There’s been a total of just over €54bn issued across European CLOs since 2013. There are 36 managers in Europe and 133 transactions, so I think it’s no longer a niche product. After all, €54bn is not immaterial. But I would say that it’s still a specialised product. Investors understand the structures, as Ian said, and they see that there is real value in the notes through the capital structure in CLOs. 

GlobalCapital: Compared to other credit products, do you think the spread premium in CLO debt is an accurate reflection of the complexity of the product? 

Nochimowski, BNPP: It’s never really accurate, that is why there is an opportunity. As we have been saying, it has proven to be a strong product from a credit standpoint. If you look, for example, at what’s happening recently: CLO spreads have been relatively stable over the last few weeks, while credit indices have come in significantly. So there is some relative value, and I think it still represents a very interesting opportunity to get access to European loan portfolios managed by established managers. 

GlobalCapital: Is that spread stability more a reflection of the fact that CLOs are less liquid than other credit products?

Nochimowski, BNP: There are lots of components to this, of course. It’s a more specialised product, so you may have less liquidity and more regulatory costs also to hold the notes. But it has some relative value and I don’t think you have a lot of competing products with similar spread levels. 

GlobalCapital: Let’s move on to the leveraged loan market. Levels are very tight at the moment, but what do you think could cause loans to widen in the medium term?

Reynolds, Spire: We see this as a technical market, so there’s an imbalance between supply and demand which has been driving the pricing. Supply has increased because investors have seen the attractions of the asset class.

The obvious answer is once the equilibrium is restored, you’ll see some spread widening. The question is, when will that happen? It could be that some large transactions currently being discussed come to the market and take away some of the excess supply. Also we need real new product in the leverage loan space. 

Or maybe it comes from tightening going too far so the arbitrage doesn’t work anymore and supply is constrained. Another factor could be some event or a general increase in default levels which affects the performance of the CLOs. We don’t see increasing default levels anytime soon, looking at the performance of the underlying collateral. Ian, maybe you’ve got a view on default levels. 

Perrin, Moody’s: I think we still are in a benign economic environment. Interest rates in Europe are very low so companies have very little to pay on a periodic basis. That supports very low default rates. Our expectation of the default rate is around 2% for the year, which means that you don’t expect really the pressure to come from that angle. 

But there’s potential in Europe, I would say. The leverage market is still very small compared to the US, if you compare the diversity score of European portfolios to the ones of US portfolios, there’s a lot of room there. There’s hope in the market that it could grow. Some industries here are not really using the leverage technique, so this could potentially help the imbalance between supply and demand. But it’s taking a lot of time for the market to get to that level. 

Nochimowski, BNPP: We can see two different technical factors that can cause a widening of spreads in the end. It can come from CLO equity investors that do not accept going below a certain yield. If new issue CLO creation is slower, this could actually translate into wider loan spreads, as CLOs represent a big part of the leveraged loan demand. 

But it could also come from the supply side, if we have more volume on loan origination. I think we’re starting to see more loan volumes this year compared to last year. Of course there is a lot of refinancing and repricing activity in these numbers, but there is also hope to see more volume driven by M&A activity.

GlobalCapital: I’ve seen notes from investors talking about the leveraged loan market and saying that, given how aggressive documentation and pricing has become, they’re concerned about credit skeletons creeping into leveraged loan market. Do you have any such concerns?

Reynolds, Spire: Well, you mustn’t forget that this is actually a sub-investment grade credit. 

As such, lenders have a higher degree of control than investment grade. For example, we have security over the assets and there are certain covenants built into the documentation, although maintenance covenants are probably a thing of the past. So there are restraints on borrowers and protections for lenders. Lenders are also getting paid a premium for the sub-investment grade risk. 

The best way to mitigate idiosyncratic risk is by building a broadly diversified portfolio, as Ian said. That’s what CLOs are designed to do. 

In terms of skeletons, I don’t think there is a big problem. There are some sectors that are more challenged than others. I would just list the old perennial, the retail sector, which suffered a lot during the crisis. Some of the media companies, cyclical businesses, chemicals, autos, construction, they may be vulnerable in a future crisis. 

We look at what is appropriate leverage for the sector and for the particular company within that sector. It’s not a one-size-fits-all. We try to gauge differences between risks and relative return. 

Perrin, Moody’s: From our point of view, we see how managers have learned the lessons from the crisis. There was a lot of talk about zombie companies a couple of years ago. As Rob was saying, in the CLO 1.0 space, retailer, directory businesses, these were very popular names. Managers have traded out of those names in the CLO 1.0 space, and clearly stayed away from those in the CLO 2.0 space. Retail, which used to be in the top three industry in the CLO 1.0 space is now number eight or number nine in the CLO 2.0s. Managers are doing a great job at selecting the names and therefore avoiding some of those multi-defaulters. 

Nochimowski, BNPP: The performance in the 2.0 market is pretty strong, almost no defaults. Even the triple-C bucket is extremely low, a picture very different to the 1.0 space, which is in amortisation mode and where there’s a natural trend of declining quality among what’s left in the pools. 

It’s also important to say that manager rules have changed since 1.0 world. In 2.0 world, there is less ability to amend and extend loans beyond maturity of the CLO, so investors have better predictability of cash flows. Also, the language of reinvestment after the Reinvestment Period is more common and more standard in the CLO documentation. Generally, the market has learned the lessons of the 1.0 world, both in terms of sector diversification, but also in terms of CLO documentation. The picture is relatively strong right now. 

Perrin, Moody’s: I would say from the trading point of view, it must have been very difficult to trade CLO 1.0 in the secondary market, because literally every single transaction had different documentation. Every bank or every manager was trying to have their own little thing that would differentiate them from the rest of the market. I think the CLO 2.0 really has become a global product. I think the managers on both sides of the Atlantic, the arranging banks on both sides of the Atlantic, the investors on both sides of the Atlantic, all want the product to be as common as possible. It helps trading if everybody has the same criteria, the same rules. It’s not strictly perfect yet, but we’ve moved towards getting a product which is much more standardised across the documentation. As you’ve said, David, the documentation is more flexible. I think in terms of reinvestment, post-reinvestment criteria, for example, managers have much more flexibility to trade in and out of names, which has helped mitigate the impact of defaults. 

GlobalCapital: How has the rise of managed accounts and other competitors in the leveraged loan investor base changed the picture for the CLO managers?

Reynolds, Spire: The picture has changed but we welcome competition, anything that increases the scale of this market is welcome. I would add, or rather reiterate, what I said earlier that CLOs have a 20-year track record. 

CLOs have developed appropriate structures, managers have established platforms and have proven ability to manage the asset class, they also have trading expertise and a proven model. Managed accounts and direct lenders are buying leveraged loans and the percentage has increased in the last year or so as new funds have been raised.

Time will tell whether or not that model works; it’s lower leveraged, it’s looking for lower yield, and it lacks the standardisation that the CLO model now has that we’ve talked about. It has the benefit of a lower capital weighting for some investors. So we welcome the arrival of new investors — it improves liquidity and it should increase the market’s size so everybody benefits.

GlobalCapital: But if it’s driving down yields on the underlying assets, is that making it more challenging for managers?

Reynolds, Spire: It’s part of the supply side of the equation.

Nochimowski, BNPP: We’re seeing the same trend in the US, where retail loan funds have become an important part of the leveraged loan market demand, which does introduce some volatility. But as you know, for CLOs, loan spread volatility could also be positive. Equity investors like to see higher yield on the portfolio, so there are two sides to this issue. Yes, we’ve seen more funds being raised for direct lending, but many of them do focus more on middle market names as they have more yield than broadly syndicated loans, so the focus is different. Therefore, these funds don’t seem to be a real game changer for CLOs. CLOs still represent a big share of the buyer base for broadly syndicated loans.

This is an important factor as CLOs represent a stable buyer base for loans. CLOs are buy and hold vehicles and they’re important in keeping stability in the loan market and in the economy. I don’t see the rise of managed accounts and direct lending as a real game changer from that perspective.

GlobalCapital: There was a recent Moody’s report talking about the amount of cov-lite loans in CLO portfolios, and whether this was undervalued — what drove that research, Ian?

Perrin, Moody’s: When you look at the evolution of CLO 2.0s, the size of the cov-lite bucket has been increasing. And we are asked regularly by investors whether this is a concern. It’s interesting because you have different opinions when you’re discussing this with collateral managers and investors.

We see that the percentage which is reported in interest reports is generally low compared to the proportion of cov-lite loans in the market these days. So we spent some time looking at it and I think the real difference comes from the fact that ultimately there’s no clear definition of what

cov-lite is. 

Basically in the CLO you’re either cov-lite or you’re not cov-lite. It’s pretty binary. In reality, you have various shades of cov-lite so the numbers are slightly different because of that. Ultimately what we found was that the managers were not necessarily buying more cov-lites than what the market had.

There are a lot of new buyers in the leveraged loan space who may be interested in buying a loan that suddenly a CLO doesn’t want to hold anymore. That’s why from a manager’s standpoint, the cov-lite hasn’t been really much of an issue.

Investors are focused on it mostly because, from a recovery rate standpoint, there’s a view that if you delay the recognition of the default your recovery rate expectation is going to be low. Studies that were done in the pre-crisis era showed no big difference between recovery rates. But I think it was a small segment at the time and it was mostly US-based, so we will have to see what the next cycle brings to this in Europe.

Reynolds, Spire: If there’s a maintenance covenant in the RCF and the RCF is parri passu, then it’s not cov-lite according to the definition in the CLO. 

Cov-lite is appropriate for larger borrowers who can access capital markets as well. From our perspective these larger borrowers are often lower risk. When you do have a covenanted loan, these days it tends to be to a smaller borrower with a higher risk profile.

It’s difficult to determine with the smaller covenanted loans whether the premium pricing relates to risk or whether it relates to liquidity. As this market evolves, as Ian said, we’ll see how the various different products develop but we’re now seeing cov-lite as an established feature of the marketplace.

Nochimowski, BNPP: Yes it’s an established feature of the market, as it is in the US. Unsurprisingly 70% of the assets in a CLO now could be cov-lite. But we haven’t tested yet the credit quality of these credits and the definition of cov-lite loans is still very broad. In most cases, as Robert was saying, the good quality issuers are the ones able to issue cov-lite loans. So in terms of expected loss — which is a combination of default and recovery — we don’t have a full picture today if it does perform worse than a non-cov-lite loan.

GlobalCapital: How are you finding the tightening in leveraged loans — is it making it difficult for managers to hit their weighted average spread tests in new deals?

Reynolds, Spire: The weighted average spread is not the whole story. There is a matrix of other measures. Yes, spreads have come down, but the answer will depend on where spreads are in the medium term. Really, the question is how does it affect returns? This is a slightly broader perspective. Returns have actually held up well and they’re beating the model. The reason is because the model includes certain assumptions about default rates and recoveries and we’re in a low default environment.

So most CLO managers have been able to hit their targets despite the fact that spreads have come in, and most of the models have a conservative perspective on spreads over the longer term. I see spread tightening as an element of the whole picture and CLO structures have a broader perspective than just spreads.

Nochimowski, BNPP: With a CLO you can’t just look at the picture today — it’s constantly evolving. With a four year reinvestment period, the market can turn so the spreads that we’re seeing today may not be the ones we’re going to see tomorrow. That is why, for equity investors, a big element of their investment assessment is the reinvestment spread.

Also, the ability to refinance any single tranche after the non-call period is a relatively new phenomenon which was not really seen in the 1.0 era. That gives some relief to the portfolio spread compression. Just looking at the recent wave of refis and resets, it can help the deal save about 50 basis points in its average cost of liabilities, which is a benefit to the equity investors. So I think the answer is that yes the spread is tight today relatively speaking, but it may not be the same story one year from now. On top of that, you have the structural element in CLOs (refinancing of tranches) that allows the equity investor to maintain a certain level of excess spread in the deal.

Perrin, Moody’s: The ability to refinance is very powerful. The entire 2013-2014 and now 2015 vintages are being refinanced and that really mirrors what’s happening on the leveraged loan side. The ability to save up to 50bp on the triple-A tranche, reducing the weighted average costs of the capital structure, helps maintain the arbitrage for the CLO.

Nochimowski, BNPP: I think the most important part is the collateral sourcing, rather than current spread levels. On that part there could be opportunities in seeing 1.0 deals being liquidated to provide collateral to new deals to offset the lack of loans. Also we’ve been seeing deals being priced with lower percentage of identified or ramped assets in the portfolio or an extension of the “price to close” timing to allow for more collateral purchases. So I think there’re still some options in the market to source collateral although it has become more difficult. I think here is the issue rather than current spread levels.

GlobalCapital: How has the equity investor base reacted to loan tightening?

Reynolds, Spire: They’re obviously interested in the tightening of the assets. If you look at the equity investment thesis last year compared to this year, last year loan prices were below par so equity investors had the opportunity to benefit from discounts on loan purchasing and higher spreads. And they’ve also had some good early distributions which is attractive. This year equity investors are seeing a slightly different investment case, where they’ve got locked-in, lower costs on the liability side and the prospect of spread widening on the asset side.

If you’re looking at last year’s equity thesis and this year’s equity thesis both are viable. The optionality of the repricing within the liability structure gives a very interesting horizon for equity investors.

Nochimowski, BNPP: I think CLO equity in its design has an interesting profile which makes it hard to compare to other fixed income instruments. As loan spreads widen, it benefits equity holders because the excess spread is magnified in the deal. And alternatively, if spreads do tighten, equity investors may have the ability to exercise some control on the CLO debt tranches by refinancing and preserving the level of equity cash on cash distributions (currently in the high teens), so loan tightening might not have such of an impact. 

This ability to benefit to a certain extent from both spread directions can help maintain that level of cash on cash distributions.

GlobalCapital: With increasing numbers of capitalised risk-retention vehicles coming into the market do you think that equity investors are going to struggle to get allocations in deals? What alternative opportunities are there to get similar kinds of returns?

Reynolds, Spire: The first part of your question is fairly straightforward. If you look at the volume of CLO issuance in Europe of about €16bn-€17bn a year, equity demand is about €1.6bn-€1.7bn a year. 

I don’t think that the scale of the new vehicles is yet sufficient to match that demand. There is still direct equity available. And equity investors can also look to invest in these new vehicles as well and get a more diversified equity investment than hitherto.

Nochimowski, BNPP: I don’t think this is such a big problem for equity investors. Even if a risk-retention vehicle buys, let’s say, the majority of the equity, there is still quite a lot of equity left to sell. And it’s not new phenomenon— since 2013, European deals have had to be risk retention compliant so you always had the presence of a manager or originator in the equity of a deal in Europe.

GlobalCapital: Where do you think best value for debt investors currently is?

Nochimowski, BNPP: If you look at the CLO debt today I think you have two main types: you have the debt that it’s issued at par (all the investment grade tranches) and you have debt that is issued at a discount to par. We see that once a senior bond moves to the secondary market, there is a good chance of it trading above par, making a natural barrier to further spread tightening as investors want to be protected from refinancing risk. So I think that bonds that still show discount to par could have some potential because they are less limited by this natural barrier to further spread tightening.

GlobalCapital: And what part of the capital stack are we likely to see this in?

Nochimowski, BNPP: Investment grade tranches issued at par are now usually trading above par in the secondary market. Double-Bs, single-Bs are issued at a discount. They have price convexity but they also have longer duration and volatility in the returns. So it really depends on investors and what their return profile is. The fact that so many investment grade bonds trade above par is an element that has to be taken into account in valuing CLOs.

GlobalCapital: How does it look from the other side of the equation, when you’re selling CLO debt, Rob?

Reynolds, Spire: Investors differ according the size of their investment, their rating targets, the duration, the returns they require, etc. So my answer is that all debt tranches represent good value, in particular vis-à-vis other asset classes of similar ratings and duration. I also think that investment in the debt tranches of new CLOs represents good value as well. As David mentioned, in a lot of the older CLOs, certain notes are trading above par. 

We’re seeing increased demand from a variety of different sectors and countries and generally increased interest in credit. This is a reflection of the continuing search for yield. Investors are looking at where they can deploy their money to meet their own investment objectives and their underlying obligations to their policyholders or pensioners. So there’s a demand for an established product that gives a predictable yield at the top of the capital structure. 

There’s also a demand for debt tranches that give good returns relative to the underlying collateral. For example, the single-Bs in the CLO structure are paying better than single-B loans, which is remarkable because they benefit from enhancement and diversity.

Nochimowski, BNPP: Given that the credit performance is generally good across the history of the product and spreads are relatively attractive to other segments of the credit markets, I agree that all tranches have some value. My point is that the market is evolving and there’s more complexity now in analysing different parts of the capital structure. In any case, it’s hard to find a competing product that is actually providing these types of spread levels in the fixed income space.

GlobalCapital: Are investors more interested in floating rate debt compared with fixed rate?

Nochimowski, BNPP: We do see some fixed rate tranches that are issued also to fixed rate investors. The risk is being mitigated as the asset side can invest in some fixed rate loans so there could be a natural hedge.

Perrin, Moody’s: Generally you have a natural hedge between the managers committing to buy a certain percentage of fixed rate assets to offset the fixed rate liabilities that are being issued. Putting a hedge is something that is not really done anymore. It was mostly seen in the CBO days where the collateral was by nature fixed rate instruments while the liabilities were floating rate. We see that less and less now although the ability to put a hedge in place is in all documentation generally. 

Where hedges were very common was on the multicurrency side but this is also something which seems to have more or less disappeared from the market. I guess it will be interesting to have Rob’s point of view on that. Pre-crisis, the European CLO market was a multicurrency market with triple-A tranches being issued in several different currencies. We’ve heard of clear interest from the managers but not that much interest from investors to have FX risk introduced into transactions. So far in the CLO 2.0 space, there has been one deal per year done with a multicurrency element to it except in 2016 where all deals were euro-denominated only.

Reynolds, Spire: It’s a dynamic portfolio so it changes week to week, month to month. There’s an obligation on the managers to hedge non-euro exposures. We’ve taken the line that we prefer to just have euro assets and the reasons are that, first of all the hedging can be quite expensive so you reduce the spread. Swaps also introduce a degree of illiquidity into the underlying asset because you need to close out the swap at the time you sell the asset.

So our approach has been to keep it simple: euro assets, euro liabilities.

GlobalCapital: To round up the conversation, are there any other topics you would highlight? 

Nochimowski, BNPP: I would highlight the fact that we are seeing more and more alignment between US deals and European deals. The euro CLO market is becoming global, risk-retention rules are effective in both jurisdictions, investors have become global and I think we will see a continuation of this trend. Investments will just flow from one market to the other. I think we’ll see more deals that are dual compliant in risk retention to satisfy this global investment base. This is an opportunity for CLOs to grow and become standardised which should benefit everybody in this market.  

   

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