Complacency could kill the CLO cat

CLO managers, bankers and investors were in party mood at the Global ABS conference in Barcelona last week.

Rapid tightening of liabilities and near-record levels of issuance in the first half of the year has made the market bullish for the rest of 2024.

In an anonymous poll, two thirds of the audience of one panel predicted that triple-A rated CLO spreads will tighten to 130bp-140bp over three-month Euribor by July. The panellists did not object.

This optimism to some extent ignores the fact that primary CLO activity is running on investor desperation and scraps of loan supply.

Central banks have raised interest rates, but huge amounts of money from the low-interest era are still sloshing around in the system and need to be deployed.

Institutional buyers like CLOs because they are a floating rate asset — good in a higher-for-longer interest rate environment — and because they are still cheap compared to other credit assets, especially at the top of the capital stack.

They are also getting cash back from amortising older CLOs that they need to put back to work to maintain levels of assets under management. Several investors have described a feeling of having to run just to stay in one place.

On the other side, CLO managers whose deals are being paid down rather than reset — spreads are still too wide to reset anything outside of the late 2022 to early 2023 cohort — are under similar pressure to keep their AUM stable by issuing more CLOs.

The CLO market is not growing, it is in a recycling frenzy.

That is reflected on the loan side. The primary market for broadly syndicated loans is also busier than at any point in the past two years with around €47bn of issuance since the start of 2024, according to one panellist in Barcelona.

But activity is driven by maturity extensions and refinancings, as the big demand from CLOs allows any halfway decent borrower to reprice their deals. Some companies are refinancing direct lending deals into the BSL market, but there is still little true new supply from leveraged buyouts.

The revival of the M&A market is as elusive as it was last year. Of course, market participants are professional optimists. There are no deals now, but you should see how busy we are behind the scenes, loan bankers say, as they have for the past year.

Rating agency analysts theorise that lower rates volatility could help private equity sellers and buyers bridge the valuation gap, or that private equity was only waiting for were lower rates, and now that it seems they will stay high for a while, they might just feel pressured to sell after all.

But there are no tangible signs of imminent recovery.

In the meantime, CLO managers keen to satisfy investor demand for deals have two options: buy expensive loans in the secondary market, or reach for riskier credits in primary.

Simplified, one approach hurts the arbitrage, the other increases tail risk.

Investors seem unconcerned about credit risk, to the extent that one CLO manager called them “complacent”. Several managers told GlobalCapital that investors frequently asked them about the struggling French telecoms company Altice at the conference — Moody’s downgraded its Portuguese branch to triple-C last week. Single-B tranches, the riskiest debt in the CLO capital stack, seem to have widened slightly in the past few weeks.

But for the most part, market participants like to point out that European CLOs have an ample cushion in their triple-C buckets, that loan defaults have, as one described it, “peaked and passed” and that cases like Altice are idiosyncratic, not sectoral or systemic. And even if something bad was to happen, no investment grade CLO tranche has ever not been paid back.

An investor recently described triple-A CLO paper as a “no-brainer”, which is a bold statement at the best of times, but especially when the future seems as uncertain as it does now.

Propelled forward by its own need to keep going, the CLO market has developed a tendency to ignore any macro or geopolitical events over the past six months. The escalation of the conflict in the Middle East was forgotten after a little wobble in mezzanine pricing.

The European Central Bank cut interest rates by 25bp in June, but its president Christine Lagarde admitted on Monday that “some [inflation] numbers could have been better” and warned markets not to assume that there will be a linear series of cuts from here.

Over the weekend, the EU's parliamentary election resulted in a big shift to the right. The move right in France was so drastic that French president Emmanuel Macron called a snap parliamentary election.

The move shocked SSA and FIG issuers into dropping deal plans, but the securitization market shrugged it off with the verdict that there would be no short-term consequences, apart from maybe some implications for EU regulations.

On Tuesday, a CLO manager told GlobalCapital that most CLOs have a high exposure to France, and a victory for the far-right would likely lead to investor questions about the impact.

Maybe all will be well. Maybe the new governments in the EU and US after November's election will prove economically sensible, there will be a soft landing, LBOs will rise in the next six months and the market will be glad that CLOs were ready to hit the ground running and finance the economic upturn.

But celebrating a market thriving on technical factors rather than thinking through the fundamental risks seems like a dangerous approach in the meantime.