US and European CLOs: stormy evolution of an asset class
The months since the coronavirus outbreak have proven to be an extremely turbulent time for European and US CLOs, bringing a new crisis in corporate credit, rather than in the banking sector as in 2008. Managers in both geographies are working hard to steer their deals through uncharted waters, testing new structures and deal formats. By Tom Brown and Paola Aurisicchio.
The CLO market in Europe finds itself stuck between 2.0 and 3.0. Before the pandemic, CLOs were larger, with longer reinvestment periods. Now, pre-Covid warehouses are being cleared with temporary tweaks to structures, but with few warehouses opened since the outbreak, market participants fear a drying up of primary issuance towards the end of 2020.
European CLOs find themselves in a transition period, where existing warehouses are being brought to market in different formats than pre-Covid deals. What little dealflow there is will be structurally disconnected from the Covid-era warehouses that come after.
Since March, almost no new loan warehouses have been opened in Europe. This will eventually lead to a market drought in around nine months, sources say, falling either at the end of 2020 or in the first quarter of 2021.
“At some point we will have converted all the existing warehouses into CLOs (or they will have otherwise been dealt with), so unless new warehouses are set up now in sensible numbers we may find ourselves without anything to convert into a CLO down the line,” says Suril Patel, a partner at Allen & Overy. “You need to keep on planting the seedlings to make sure that in nine months’ time or so you have a pipeline of new CLO issuance.”
For the time being, the European CLO market will continue to be comprised mostly of deals coming out of warehouses formed before the outbreak. Moody’s reported there were around 40 CLO warehouses open before the pandemic, with almost a dozen already announced and cleared in the form of new CLOs.
“Warehouses being merged is an idea which has been floated around the market, but the market is very difficult to judge, especially towards the second half of the year,” says Thorsten Klotz, managing director at Moody’s.
Cross-border appetite dwindles
Before the pandemic, US manager CBAM Partners opened several warehouses, with the aim of bringing deals and retaining all tranches rated triple-B or lower. The manager had been making hires in Europe, notably loan portofolio manager Jean-Philippe Levilain as head of European credit, looking to build the team ahead of the launch of its first non-US deal. Other US managers were also said to be looking at a 2020 European debut.
“US managers who have not made the move into Europe yet have the luxury of deciding to hold off for now, whereas managers who have made the journey over already have assumed all the sunk costs of establishing a European platform so will be making decisions on their new deal activity from a completely different perspective,” says Patel. “I think in terms of new managers coming in it will really drop off while they wait to see what’s happening.”
Compared with the US market, European CLOs have less exposure to the energy, tourism and retail sectors. No CLOs have yet breached their overcollateralization (OC) tests, as has occurred in a number of US deals.
“The US CLO market was exposed to oil and gas, particularly in 2016 when prices fell significantly,” says Christophe de Noaillat, managing director at Moody’s, explaining the disparity between US and European CLO performance. “There is also a wider diversification of industries in the US than in Europe, which means there’s a slightly lower credit enhancement in the US.”
On June 3, Moody’s placed 77 broadly syndicated loan CLOs on review for possible downgrades, mirroring similar moves from Fitch, S&P and DBRS. Further downgrades are expected in the coming months, lagging the US market.
Triple-C buckets on average have doubled to around 7% as of May, and there is a large dispersion of triple-C buckets across European deals, according to Moody’s.
Morgan Stanley expects triple-C exposure to increase from between 8% and 9% to 14% if rating agencies downgrade loans. Research from the bank shows that an increasing amount of euro CLOs are seeing equity payments deferred, with 4% of 184 euro CLOs seeing missed payments on the equity.
This is not necessarily a sign that deals are performing badly. “If some of the remuneration that would normally go to the equity is used to buy additional assets and they are bought at a low price, then it may generate a better return on the equity,” says Klotz.
Testing new formats
The months following the pandemic outbreak saw US managers return to a crisis era deal format known as “print and sprint”, where managers lock in pricing of the bonds before acquiring the collateral. While US firms have used print and sprint deals frequently since the crisis began, the model is less common in Europe.
Structural changes in European CLOs will be slight, in contrast to the big differences between CLO 1.0 and 2.0. The way deals are formed and executed will evolve over time but the difference will be less noticeable than in pre- and post-2008 transactions.
“I think that the dynamic is a temporary one until market conditions get back to normal and we have cleared this backlog of warehouses,” says Patel. “There could be a lesson or two learned from this current experience. People might say we need more triple-C flexibility in these deals, for example, but in terms of the permanent change of the structure, I think it will be quite a slight change to the deals rather than a massive one.”
US CLOs re-emerge, changed
On April 2, Blackstone’s GSO unit priced a $477m static CLO, re-opening the market in Covid era. The CLO ended a 16 day drought in the primary market and ushered in a distinct new era for the sector. Deals that have come since have no longer been printed in the classic format, with four to six year reinvestment periods. Rather, deals have been static or shorter in duration.
Since the restart in April, the US CLO space has yet to return to pre-virus issuance activity and deals have adapted themselves to the market volatility showing common traits in terms of structures, duration and leverage.
In the first “shock” phase, managers and investors found refuge and certainty in static deals. As the situation developed over the course of April, CLO issuance took off gradually, returning to actively managed deal formats.
However, CLOs became smaller in size, at around $200m-$300m instead of the pre-Covid norm of $500m or more. The structures mostly consisted of four debt tranches rated from triple-A to triple-B and the average reinvestment period was two years, with few attempts at a three year reinvestment period.
“Early on, a small handful of static deals were issued in an effort to capture opportunities in declining loan prices,” says Dan Wohlberg, director of Eagle Point Credit Management. “However, the market swiftly moved to multi-year reinvestment period CLOs, as investors and CLO collateral managers alike valued the ability to trade during these periods of volatility. Over time, we expect reinvestment periods to continue to extend to their pre-Covid lengths as issuance rebounds.”
Following the outbreak, analysts revised their forecasts for new CLO issuance, predicting a steep drop from $90bn projected at the beginning of the year to about $55bn for full year 2020, according to Deutsche Bank.
CLO issuance reached around $25bn by the end of May, compared to $50bn in the same period of 2019. In mid-May spreads on triple-A CLO paper hit the tightest level since the beginning of the pandemic with a deal priced by Ares Management. Senior tranches were sold at 170bp over three month Libor, compared to almost 200bp priced in April.
“Triple-As continue to be one of the few highly rated asset classes never to see an impairment, and with that in mind we believe CLO triple-As will be at least as tight or tighter than where they had been pre-Covid,” says Wohlberg, referring to his spread target through this summer.
A tool to resuscitate the wider CLO space might come from the Federal Reserve’s Term Asset Backed Securities Loan Facility (TALF), but it would have to be expanded to include actively managed deals, rather than just static CLOs as it stands now.
“If the Fed wants to fix the economy, they should be more mindful of CLOs that buy roughly 70% of leveraged loans,” says Olga Chernova, founder and CIO of the hedge fund Sancus Capital Management. “Leveraged lending can help American corporations get back on their feet. If the Fed tweaks the TALF programme, it could be a very powerful instrument.”
The interest rate for TALF loans has been established at 150bp over Sofr. “It is expensive,” says Chernova, and it might be “obsolete” because the market has already priced triple-A at 170bp and “we’ll get at 150bp very quickly”.
CLO players say the crisis overall has shown that the deals are resilient and adaptable. Managers and investors see similarities between the time under Covid-19 and the 2008 financial crisis in terms of CLO structures and reactions of the market. Yet the age of coronavirus crisis has taught some new lessons as well.
Wohlberg sheds light on what he describes as a “known-unknown” in the CLO space.
“It has been educational to see how different CLO collateral managers approach their deals, structures and documentation,” he says. “Bifurcation in views on credit are expected in a market such as this but the differences in expertise in deal negotiation and laboratory-like use of CLO provisions is creating some differentiation in triple-C and over-collateralization test management, and therefore in ultimate outcomes for investors. We expect this differentiation to increase over time, especially if volatility or downgrades continue.”
Another lesson might be learned from the frenetic pace of leveraged loans downgraded by the major rating agencies. Almost 13% of CLOs, according to Fitch Ratings, have breached their 7.5% limit on holdings of triple-C loans, which has led some CLOs to fail the junior overcollateralization test.
“If we are going to have extreme situations in terms of downgrades, it would not surprise me to see more flexibility given to managers,” says Chernova.
“In the long-term, a manager might request to see the increase in the triple-C buckets as force majeure in the documentation.”