The Euro pean CLO asset class has lain dormant for years but there are signs it is stirring. Three transactions have been priced this year and several more are in the pipeline.
However, if the market is to remain sustainable, equity investors should not expect the turbo-charged returns of 15% that they used to enjoy. Analysts at JP Morgan warned this week that clinging to such targets could mean taking on "an uncomfortably high degree of risk".
Like many other asset classes, the European and US leveraged loan markets are being severely affected by challenging technical conditions. New loan supply is being dwarfed by exceptionally strong demand in both the US and Europe.
There have been strong inflows to US loan retail funds and loan exchange traded funds and they have taken a lot of the raw material that would have otherwise been put to use in CLOs.
As a result, only 10% of this year's US leveraged loan volume has been made up of new loans. The remaining 90% has come from existing loans that have been refinanced — usually at tighter spreads.
Last year US loans would typically have generated a spread approaching 400bp over Libor, but today the spread ranges between 300bp-350bp over. And where US loan prices go, Europe tends to follow.
Despite that contraction, legacy CLOs were able to deliver attractive returns to their equity investors as the debt liabilities were funded at vastly cheaper levels. In 2007, triple-A CLO tranches were typically priced at around 25bp over six month Euribor, compared to the 130bp over in the latest European CLO from Apollo.
But these legacy deals have come to the end of their reinvestment periods and, with that, the ultra-cheap financing that they once provided is no longer available. So unless CLO investors make some pretty wild assumptions about the yield that prospective loans might deliver, then expectations of equity returns must decline from the 15% that was once the norm.
Even at a much reduced yield of 10%, CLO equity returns would be among the last bastions of value in the market. Investors need to recognise that and not be tempted into risks that could push a recovering business to destruction.