US, European CLO markets take downturn fears in their stride
The CLO is one of the more transatlantic sectors in securitization, and has grown more so in the past year as US managers make new inroads in Europe. However, both markets grapple with unique issues. In the US, a rocky corporate credit landscape has put the fear of widespread downgrades front and centre, while in Europe, the space is getting crowded and competition for collateral and persistent negative rates weigh on the sector. Both markets in 2020 are headed for an inflection point. Max Adams and Tom Brown report
A number of US managers debuted European CLO programmes in 2019, while European managers were often scouring the US for leveraged loan collateral. This overlap between the US and European markets, both in issuer participation and CLO portfolio make-up, is unique in structured finance.
What’s more, both markets share a whale of an investor in Japan’s Norinchukin Bank, which is often credited with propping up the market and dictating levels at which triple-A CLO paper prices. Though the bank has pulled back from Europe somewhat under scrutiny from its domestic regulator, Norinchukin is still a player in the US.
The continued success of both markets as the late innings of the credit cycle stretch endlessly on demonstrates their relative value in the wider fixed income universe, as well as investors’ confidence that the sector is holding up even as rumblings of a downturn increase. Even though central banks and regulators around the world sound the alarm around the asset class, it would take a crisis much larger than the one in 2008 for triple-A investors to incur principal losses.
Winners and losers
For a year that began with widespread predictions of an economic recession, 2019 was a benign one for US markets. Equities at the end of the year were hovering around all-time highs, and consumer and employment fundamentals were strong. But leveraged credit markets are looking at different signals and 2020 could separate the winners and losers in US CLOs.
Bullish sentiment returned at the end of 2019, pushing the Dow Jones Industrial Average close to 28,000. Similarly, in CLOs, returns in 2019 outperformed the year before, with the JP Morgan CLO index returning 4.19% compared to 2018 returns of 2.59%. But CLO market players say that 2020 is a year that idiosyncratic risks will grow, and investors and managers should be looking to shore up their defensive positions.
A big part of this has to do with the looming threat of downgrades among leveraged loans — the underlying collateral of a CLO — as US corporate credit weakens in specific sectors such as retail, healthcare and energy. Moody’s and S&P Global Ratings downgraded a combined 421 loans worth $272bn in 2019.
According to analysts from JP Morgan writing at the beginning of November, if downgrades over the next nine months continue at the same pace as the previous nine, the percentage of loans in CLOs rated single-B minus will go from 14.4% to 24.1%, while loans rated triple-C will increase from 10.9% to 17.8%.
This is a big increase and a hugely important number for CLO managers and investors to keep track of. That is because CLOs are structured with “buckets”, or a set limit on how much collateral of a particular rating they can hold at any one time. Most CLOs are capped at 7.5% for their triple-C bucket. After that, certain tests that are built into the deal to monitor its performance are triggered, and failing those tests can lead to cashflows to the equity investors being shut off and diverted to bondholders in the deal.
“We have long thought that the triple-C bucket and triple-C haircuts are the number one vulnerability of the CLO market,” says Ellington Management’s Rob Kinderman, partner and head of credit strategies. “A handful of downgrades could start to impact the overall market.”
Despite some fears that a wave of forced selling could wash over the market in the event of loan downgrades, CLOs are not forced to sell in the event that certain ratings buckets overflow. They are, however, incentivised by the rules governing the CLO structure to shed lower rated loans.
“Downgrades can put a deal at risk of shutting off interest cashflows to the equity and subordinate management fees. The manager is incentivised to shed the assets that otherwise trip these triggers,” says Greg Borenstein, portfolio manager in Ellington’s CLO management group. “When the CLO market went through the crisis, most of what caused interest payments to be shut off was downgrades, not actual loan defaults.”
The fact is that the number of defaults would need to be nearly three times the level observed in the crisis in order for triple-A investors to be hit with principal losses. So the market has rightly shifted much of its attention to the downgrade issue, and the risk that CLOs are exposed to lower rated collateral has grown as CLOs become the primary buyers of leveraged loans.
As the US Federal Reserve changed course in 2019 to embark on a path of interest rate cuts, floating rate products became less attractive, and outflows from loan mutual funds and ETFs accelerated. According to Maureen D’Alleva, global head of performing credit at Angelo Gordon, CLOs account for as much of 70% of the buyer base for leveraged loans at the end of 2019.
“Because what we find is ETFs are not buyers, it is the CLO warehouse, which ultimately becomes the CLO, which is the primary buyer,” D’Alleva says.
Loan pickers are the new stock pickers
Picking and moving out of credits that are likely to underperform, then, will be of heightened importance in the coming year.
Rather than simply trading in and out of loans that overflow a ratings bucket or breach certain tests in the CLO, managers are going to need to identify risks among loans that may have the same rating.
“We really think having a very close eye on risk is extremely important,” says Rizwan Akhter, managing director and head of CLOs at York Capital in New York. “There are a lot of questions around triple-C downgrades, but we take a little more nuanced view because not every B3/B- loan is created equal. Some are exposed to cyclical risk and some others are doing fine.”
Akhter goes on to say that the disconnect between the upward trajectory of US stocks and the widening of CLO debt points to something amiss in the markets. The US stock market is trading at or around all-time highs, but certain tranches of CLOs, particularly double-Bs are at their cyclical wides.
“That is very disconnected, and investors are rightly concerned,” Akhter says. “We think that we are coming into a period where CLO managers will have to be very strong on picking out fundamentals and strong on risk management. You need both.”
Similarly, high yield bonds are at post-crisis tight levels, while the mark-to-market value of loans has lagged. This goes against conventional wisdom, as the loans are senior secured in a company’s debt structure, but it is a technical quirk of the current market that points to investor preference for fixed rate product over floating in a falling yield environment.
All of the mixed and confusing signals flashing across screens in 2020 will make picking winning credits all the more difficult. A combination of high corporate leverage and the enduring trend of cov-lite loan documentation will reduce recoveries compared to previous credit cycles, according to Steve Vaccaro, CEO and CIO of alternative credit manager CIFC.
“We are also very actively risk-managing our portfolios and looking to sell positions that we see underperforming. We believe it is better to actively manage risk manage versus blindly holding underperforming loans through defaults and restructurings,” he says.
The bad eggs in leveraged credit will be familiar to anyone paying attention to markets in the past few years. Energy has had issues since the oil and gas market seized up in the summer of 2016 and oil collapsed from a high of over $100 per barrel. Retail is also ailing, and has been for some time, battered by headwinds coming from e-commerce.
“We are definitely not ignoring the ratings issue, but the types of situations we are trying to avoid are ones in which there are credits with very little cashflow,” Angelo Gordon’s D’Alleva says, adding that in addition to energy and retail, she is also paying close attention to healthcare, which is pressured by a wave of political and regulatory changes proposed by lawmakers in the past year.
Ultimately, times like this end up being a proving ground for CLO managers, and they come around only a few times in a cycle. Investors will be watching closely for performance issues among managers and will end up more carefully deciding who to park their money with.
“We view this period of stress as the third major opportunity to assess manager performance in the last 10 years,” Vaccaro says. “The first two periods of stress during this time were the financial crisis that broadly ended in 2009, and the oil and gas stress that broadly ended in 2016. We believe CLO investors will be closely monitoring manager performance in the coming months and potentially changing who they want to invest with.”
The view from Europe
Europe has a related, but also unique, set of issues. While the US market deals with credit issues, the European market is dealing with an influx of new managers piling into the space, among them many established US managers looking to import their brand to European investors. And while the US market lags behind in the realm of environmental, social and governance criteria (not just in CLOs, but across fixed income), European managers more and more are making this a marketable part of their business.
The European CLO market is getting crowded. As of 2019, there are more than 50 managers issuing CLO deals, all scrambling to put together collateral, which is noticeably rarer compared to supply in the US.
The increased number of CLO managers in Europe has resulted in more competition for collateral, contributing to a compression in asset spreads, says Charles Kobayashi co-head of CLOs at BlueMountain Capital Management, a unit of Assured Guaranty.
“Given low default rates in Europe over the past couple of years, performance across managers has generally been good,” he says. “Unlike the US loan market, we haven’t seen dispersion on the spread between BB and B assets in Europe. As a result, there has been less of a basis for tiering CLO managers in Europe.”
Before the fourth quarter of 2019, syndicate bankers said that there was around 5bp worth of pick-up on the triple-A spread for top tier managers, but now the lines between established and newer names have started to blur.
“In Europe managers are very disciplined with portfolio selection,” says Florent Chagnard, head of syndication and origination for new issue EMEA CLOs at Credit Suisse in London. “A lot of them have a decline rate of over 50%, and they are willing to take their time to ramp the right portfolio.”
Equity has been notoriously difficult to place as the arbitrage becomes squeezed. Some equity investors were given an incentive by having a “turbo feature” inserted into the deal structure — often disguised as single-B notes — which essentially act as a buffer for the junior tranche by reallocating money to repair the principal of any loss experienced on the bottom-most tranche.
These features were largely absent from the post-crisis market, with only a few deals including them in 2014 and 2015, but they have now resurfaced in order to placate equity investors.
But above all, traders and syndicate bankers highlight concerns over the credit cycle. Individual portfolio performance within CLOs has come under increased scrutiny in recent months.
“The credit standards seem to be worse than what they were five years ago,” says Emanuele Tamburrano, senior director and analytical manager for EMEA at S&P Global Ratings in London. “But the pools are growing larger, as there are more borrowers coming to the market than in 2017.”
There she blows
The market was heavily propped up by Japan’s Norinchukin Bank at the beginning of the year, anchoring triple-A CLO tranches and forcing them into its preferred price target of 108bp. Things have changed since the summer though, with triple-A tranches now landing at 90bp-95bp since the bank pulled back abruptly as scrutiny from its domestic regulator intensified. This left space for new triple-A investors to fill the Norinchukin-shaped hole.
Previously sidelined investors were also lured by another change in the asset class; the drop in Euribor rates and increased benefit of the Euribor benchmark floor embedded in deals.
“We have seen strong demand from investors in the senior tranche,” says Chagnard. “Investor demand from Asia, but mostly from Europe and the US, across banks, asset managers, pension funds, insurance companies and also a few hedge funds.”
Another change is that the centre of gravity around rating agencies has shifted. Kroll Bond Rating Agency (KBRA) launched its European CLO platform in June with a rating provided to Carlyle Euro CLO 2019-2, competing with the traditional big three rating agencies: Moody’s, S&P and Fitch.
Kroll has since rated five European CLOs in total. Writing to GlobalCapital, DBRS said that this a positive development and indicates that there is space and market acceptance for a credit opinion beyond the largest rating agencies.
ESG criteria also took prominence in European CLO language in 2019 with Fair Oaks’ debut CLO, specifically constructed to avoid collateral which would go against UN principles. That deal was followed by Capital Four in Europe, which also rolled out its CLO debut with ESG investment criteria. Permira’s Providus CLO I, a €362.5m deal that was priced in March 2018, is widely credited as the first ESG CLO.
“Over the past year we’ve received a growing number of ESG queries from European investors,” says Kobayashi. “This comes at the same time as asset managers are making a stronger push toward considering ESG criteria. We’ve recently seen more deals impose a limitation on investing in sectors which present ESG risk and have included a similar limitation in our most recent CLO transaction.”
Syndicate bankers say they have not yet received specific requests for ESG deals, which tend to exclude collateral which would blatantly fall outside ESG criteria rather than actively seeking collateral which falls inside it, but it has become a big discussion between market participants in the last year.
“It will become the market standard at some point for sure,” says Chagnard. GC