Thanks to rising interest rates and slowing economic growth, for the first time in about 15 years investors in CLOs have reason to at least consider the possibility that they might not get their money back.
Unsurprising, therefore, that some have told GlobalCapital they are taking a far closer look at individual managers than before. This will have a big effect on how they price new deals, and could make issuing painful for lesser managers. But it is no bad thing.
New managers have always had to pay up to some extent in Europe. Yet, unlike in the more discerning US market where tiering between managers is already more defined, the difference used to be a just handful of basis points.
Indeed, when Acer priced its first CLO in early February 2022, for example, its triple-A spread of 97bp was just 5bp wider than other deals by established managers that came at a similar time.
This kind of differentiation has started to become more pronounced, and is expected to get bigger. In May this year, Signal placed the triple-A notes of its debut deal at 210bp, the widest spread in Europe the year to date and 20bp outside where others were priced in those weeks.
Increasing portfolio variety
But investors say they are also looking for markers of quality beyond “have they done this before?”. And market participants even expect to see a divergence in pricing emerge between long-established managers.
For a long time, tiering between experienced managers was barely justified in Europe, since the loan market is so small that most CLO portfolios ended up looking pretty similar. But the extreme supply shortage and the rising risk of defaults have changed that situation.
Access to loans and amend & extend deals matters more given primary issuance has been scarce all year, one investor said. In addition, risk management is coming under closer scrutiny — given the fear that poor equity returns may tempt managers to buy cheaper, lower-quality credits to increase the yields on their portfolios and help the arbitrage.
The share of high yield bonds in a CLO portfolio is also playing a role in investor assessments, since bonds that pay fixed rates are more exposed to interest rate movements, and loans usually rank higher in the repayment order if a company defaults.
The portion of fixed rate assets in European CLO manager portfolios ranges widely, according to Deutsche Bank research published on Friday. PGIM, Angelo Gordon and Barings are the managers with the highest fixed rate bucket exposure, with 19%, 16%, and 16%, respectively. Around half of the European managers are grouped between 8%-4% fixed rate bucket exposure.
Just five managers have less than 4% exposure, including Partners Group, Cross Ocean Partners, and Cairn.
Benefits for all
Some of the managers who consider themselves of higher quality have been a little smug about this trend.
They can be heard arguing that managers without a big name and plenty of cash may be prone to make more speculative investments in an effort to boost equity returns, risking poor performance could ultimately turn investors against the CLO market as a whole. Today's challenging environment is not a good time for new, smaller managers to emerge, they say.
It can sound a little like these managers are just hoping that the greater tiering of managers in the new issue market will prohibitively up the cost for newbies, thus keeping the upstart new managers out of the competition.
Putting the snide remarks aside, all those with a vested interest in the development of Europe's CLO market should be applauding this development.
A healthy, mature market shouldn’t move as one. Investors should have a more elaborate choice than “this week I buy, this week I don’t”. With finer differentiation between asset prices, CLO investors are more likely to be able to persuade asset allocators to increase the cash they put towards the asset class.
This would be beneficial for all: the CLO market could certainly do with a few more investors, especially for the triple-A tranches. The universe of European CLO investors is relatively small and expansion has been slow.
Many recent deals have depended on anchor investors to take a significant chunk of the most senior notes, which gives buyers more power to push for certain changes in CLO documentation — for example, around the snooze drag — and keeps spreads wide. Demand from a larger number of investors would add some dynamism.
Given the high cost of debt for managers lately, the arbitrage between assets and liabilities has not been working in the rising interest rates environment. Deals are still getting done by CLO managers that can retain their own equity through captive funds and do not depend on third party buyers, but issuance without proper equity returns is not sustainable in the long run.
More differentiation between managers may raise the barrier to entry in the short term. But if it enables the asset class to become a more nimble beast, it is likely to attract more buyers and help to fix the crippling arbitrage problem that has kept many issuers without captive equity funds out the market.
This would benefit market participants of all shapes and sizes.