Energy security worries, the Russia/Ukraine war, China’s economic slowdown and the ongoing battle with Covid-19, global supply chain disruptions, and quantitative tightening are among a host of geopolitical shocks that have spooked markets.  In “normal times” any one of these risks could have forced a sell-off of assets.  But what is perhaps most unexpected is the confluence of these ‘Black Swan’ events, brewing up a perfect storm for investors.

At the May 2022 Creditflux Symposium,  Deutsche Bank’s Trust and Agency Services team found the mood was one of caution, but offset by moments of optimism that had also characterised the tone of the earlier IMN 9^th Annual Investors’ Conference the previous month.

The general consensus held that it is not a question of if there will be a widespread recession, but when – and whether it will be global or limited to specific countries and sectors. One speaker, for example, found it “hard to see how the UK fights stagflation”, adding that its policy responses would be “a bit of a test case for the next few years”. Given European policy responses to the Covid-flavoured “strong medicine” of quantitative easing and state hand-outs, audience members were invited to consider what convalescence might look like.

Other panelists singled out the automotive, building materials, chemicals, consumer, heavy industrials, and travel industries as looking the most fragile. These sectors face both rising raw material costs and price-sensitive customers, presenting medium-term challenges (notwithstanding their “extremely good” Q1 2022 figures).  Aside from these sectors, the lessons of Covid still hold true: companies most at risk from “softening economic conditions” are those that are smaller, undiversified (regarding geography and product), that have limited access to cash and liquidity, and lack a sponsor with the creativity to see a way ahead and with the goodwill to support their clients. 

On the plus side, with (at worst) default rates unlikely to exceed 2%, that leaves 98% of the market investable. Panelists flagged significant opportunities among issuers in the healthcare, software and telecommunications sectors. One noted that the debt-to-EBITDA ratio values look “relatively stable” (although that leverage increased, since “anyone who could have tapped the market last year did”), and ratings have also been “solid”.

“While loan volumes are down, there is a reasonable pipeline”
Adam Chalk, Vice President of Sales, Deutsche Bank Trust & Agency Services EMEA

Deal flow

Adam Chalk, Vice President of Sales at Deutsche Bank Trust and Agency Services EMEA reported that, unlike 2020 when Covid-19 hit, there was no widespread pull-back at the onset of the Russia/Ukraine crisis, and so while “loan volumes are down, there is a reasonable pipeline”. CLO volumes are, “a little quieter than last year”, but there are still around 60 warehouses out there, and it will be interesting to see how arrangers manage the flow over the year. 

John Polito, Managing Director and Head of Sales at Deutsche Bank Trust and Agency Services Americas described the CLO market as “steady”: US CLO new issuance is down roughly 15% year-on-year (although 2021 was a record-breaker for new issuance). Factoring in the loss of the LIBOR floor, the LIBOR-SOFR transition, and “lots of noise”, the arbitrage is ‘fragile’ however with roughly 200 open warehouses currently and as it’s no longer a real issue to get assets at an attractive level, while conditions are more challenging it’s undeniably a more interesting market.

In the US, relatively few CLO managers could issue now - with both sponsors and new issuers expected to sit on the sidelines. Rather than regard this as negative, investors were encouraged to consider the current environment as one of “discovery, not uncertainty”.  The general mood suggested that it would be a slower year, with greater clarity and stability being expected in its second half.  “This sentiment was echoed at the US conference SFVegas that took place mid-July,” reports Polito. “The CLO market session outlined the challenging factors for CLO issuance such as rising input costs and rates, interest coverage, hedging costs, and uncertainty around future treatment of risk-weighted assets”.

Returning to the May Creditflux event insights, one bank observed that its CLO buyer base was “quite thin”, with only 20% currently active.  But CLO investors themselves considered there was evidently liquidity in the current US market, one going as far as describing it as a “buyer’s market”.

Far from being disheartened by market uncertainty, US CLO managers are using it to seize opportunities, with many entering the European market.  There are two main reasons for such geographical expansion:

1. The number of issuers in Europe has hit critical mass, allowing CLO managers to assemble credits that give them long-term comfort.
2. The European investor base has also broadened and encompasses those looking at both European and US markets.

US mid-market CLOs

Any assumption that “small is weak” fails to recognise the evidence of the US mid-market that in fact “small is beautiful”.  For example, CLO investors are attracted to the relative value of the mid-market, along with other advantages, such as lower leverage and additional spread.  There are occasional downsides here, such as having to “work hard to get the data you need”, given the reporting regime for the US is less all-enveloping than that of the EU, as is that of its mid-market compared to the broadly syndicated loans (BSL) market.  But even this leads to a benefit treasured by mid-market investors: the less fulsome data than in BSL prompts CLO managers in this space to have more frequent dialogue – and deeper relationships – with the underlying obligors, which gives them “far more visibility and comfort” and allows problems to be addressed ‘before they arise’.  All this provides “sleep at night” value to investors. 

“The smart money is in the mid-market”, declared one panelist.  Another noted that there is “a ton of capital formation in this space” which others agreed with.  Much of that capital is now being deployed in direct lending, so much so that one speaker suggested the US market could no longer be divided between BSL and the mid-market, but rather between rated and unrated lenders.  This was said to be more than a passing trend, with further growth expected in direct lending because “US banks are being regulated out of making loans”. 

“There has been “massive development over the last 12–18 months in ESG CLOs”
Conor O’Toole, Managing Director and Head of European Securitisation Research at Deutsche Bank

Just as capital is being deployed through novel avenues, the Symposium also highlighted the continuous innovation present in CLOs, not just within structures (like the flexible use of fixed rate tranches) but also with new products coming to the fore – such as commercial real estate CLOs and, especially, ESG CLOs.

Conor O’Toole, Managing Director and Head of European Securitisation Research at Deutsche Bank noted there had been “massive development over the last 12–18 months in ESG CLOs, ESG going from something predominantly exclusionary [i.e., negative screening] to inclusionary”.  One legal panelist confirmed that the incorporation of ESG factors into CLOs had prompted numerous changes to CLO documentation as regards both prior due diligence and ongoing reporting obligations. Noting that various competing definitions and approaches to ESG persist CLO managers had at least one slide on ESG in their investor decks” demonstrating how ESG has become deeply integrated into underwriting philosophy., he anticipated a firming up of industry standards over the next 12 months.  

O’Toole said Deutsche Bank’s research found that “while around 50 deals last year were actively labeled as ESG CLOs, close to 100% of new issuances and refinancings in 2020 and 2021 had negative screening language in their documentation, and all CLO managers had at least one slide on ESG in their investor decks” demonstrating how ESG has become deeply integrated into underwriting philosophy. 

The need for objective standards, data, and technology for ESG investing was flagged, as was the importance of collaborating with third party partners in this process of moving from ‘ESG 1.0’ to ‘ESG 2.0’.   Obligors and rating agencies could play key roles here. O’Toole considered that reporting from obligors would provide the raw data for this process while one panelist, pointing to the role of rating agencies, remarked that “if we all mark our own homework, we are not going to get very far”. 

O’Toole also considered that “Article 8-aligned” CLOs would be the market’s template globally,¹ noting that US CLOs find it a useful framework and are electing to adopt it, given it facilitates inflows of European capital. One panelist cautioned that the increasing adoption of ESG means an impact on the exit from any particular legacy CLO investment.

The advent of the CLO 2.0 market has seen an increase in both the absolute number of investors and their composition.  But given how robust CLOs are and their proven performance, panelists queried why CLOs are not more popular. One suggestion was that there is still not enough money deployed to the product in the European market – certainly when compared to the US market.  Part of this is simply investor preference, for example it was observed that Asian investors currently prefer the US CLO market and have become less active in Europe.  But that feeds into the issue of liquidity, which is important in that it enables investors to sell-off in order to protect their downside, added to the fact that in the current uncertain market “bigger and more diverse is better”. 

Something of a flight to safety is being reflected in both investor appetite and accordingly in CLO portfolio construction. Overlap within some of the larger CLO funds already sits at around 45% and is expected to rise over the coming year.

CLOs might be the “golden child”, but they are not the entirety of the credit universe. That said, they still provide fair value relative to other credit products, and their fundamentals, agreed panelists, are “still looking good”.  While some may bemoan that the current CLO market itself is quiet after the bumper year of 2021, in these uncertain times that is rather a feat to be celebrated.

The Creditflux CLO Symposium 2022 from Ion Analytics was held in person in London on 10 May 2022 and also online

Sources

¹ See Article 8 of the EU’s Sustainable Finance Disclosure Regulation (Regulation 2019/2088).