CLO issuance hit record highs in 2021, surpassing even pre-pandemic levels. But do the gathering geopolitical and macroeconomic clouds on the horizon mean an end to the CLO market’s sunny spell?  Panelists at IMN’s 9^th Annual Investors’ Conference on European CLOs and Leveraged Loans held in London shared some encouraging insights and this article summarises the main themes from these.

It has been said that the CLO market took two years to recover from the global financial crisis (GFC) but took only two months to bounce-back from the onset of the Covid pandemic.

Headwinds

January 2022 saw a slow start to the year with only five CLO deals. Both 2020 and 2021 have featured extreme market volatility but have benefited from central bank support in the form of the quantitative easing. Now the storm clouds include public sector debt incurred during the pandemic, anticipation of recessions and quantitative tightening from central banks to counter rising inflation.

"The CLO market has successfully dealt with this sort of uncertainty for quite a while and has been able to find flexible solutions"
Brendan Condon, CLO Origination and Structuring, Deutsche Bank

Whilst some anticipate continued market volatility over the next 24 months, net asset values are holding up, despite the headlines. Three broad categories of headwinds facing the European CLO market in 2022 include:

1. Current loan supply is “skinny”. In 2021, the CLO market was well supported by a large amount of fresh loan issuance which helped to keep the arbitrage, spreads, and loan returns in a good state of balance. With so few loans coming through, there are many CLO warehouses that remain open.
2. Less than favourable central bank policies: This is a double-edged sword for the asset class, because while higher interest rates will hit consumers and businesses, these may also prompt a significant influx of funds into CLOs as investors switch from fixed to floating rate products, something everyone wants in an inflationary environment. Some planned bond deals that are pivoting into floating rate notes to tap into the increasing liquidity in this space.
3. Geopolitical instability: Normalised higher oil and commodity prices and rolling lockdowns in China will impact cash reserves, margins, and supply chains - but in a way that is still hard to quantify.

As for timing, few admitted they were worried, but were less concerned about the impact of these headwinds in the short term than in the medium term.  Many corporates have borrowed in a very low interest rate environment, which safeguards against immediate difficulties. 

Medium-term disruptors include: Staff shortages, supply disruptions, and an inability (in certain sectors) to pass on rising raw material costs to price-sensitive consumers who are already feeling the pinch.  To Brendan Condon, Vice President in CLO Origination and Structuring at Deutsche Bank, it was not inflation or ‘de-globalisation’ that were where the risks lay, but rather in these second- and third-order consequences of the headwinds. These include food security uncertainty in certain emerging markets, reconfiguring supply chains from China to Asia or onshoring to the US, and further semiconductor supply disruption. While all these factors could cause some volatility to the market dynamics underlying CLOs, Condon noted that “the CLO market has successfully dealt with this sort of uncertainty for quite a while and has been able to find flexible solutions”.

"The CLO 2.0 structure has proven itself, having weathered the global financial crisis and two subsequent downward cycles"
Jason Connery, Head of Trust and Agency Services EMEA at Deutsche Bank

A resilient structure

Jason Connery, Head of Trust and Agency Services EMEA at Deutsche Bank, said the CLO 2.0 structure has proven itself, having weathered the global financial crisis (GFC) and two subsequent downward cycles where commodities prices plunged.  Some thought CLOs had not really been tested during the Covid-19 pandemic given the significant levels of government support to obligors and markets generally. Despite this, the abruptness of the global lockdowns triggered in March 2020, during which many businesses and governments faced a “zero revenue” model, did indeed test the mettle of CLOs. 

Credit selection is (as ever) the key, because even two companies within the same sector may behave differently in these headwinds.  Moreover, all felt that the rigorous credit analysis and selection processes that underpin CLO structures, honed over the last decade, rendered them more than resilient enough to cope with the current maelstrom. 

The ‘loose’ documentation that was much discussed in the market pre-Covid and pre-Ukraine proved to be precisely what enabled people to survive and enabled additional capital to be brought on board.  Such resilience and in-built flexibility in CLO structures was observed with no major changes to CLO documentation, barring new issuances now including some additional wording regarding sanctions to accommodate the Russia-Ukraine situation. 

Fixed versus floating

While there has been increased interest in floating rate products like CLOs, there has also been increased interest in fixed rate buckets within CLO structures, noted Deutsche Bank’s Condon.  He said this was driven by two trends – in warehouses and new issuance. 

• Market dislocation and warehouses. CLO managers are requesting increased fixed rate bucket allocations.
• New issuances. There is an increased allocation to fixed rate buckets within new CLOs – up from the usual 10% allocation to now 15% and sometimes 20% – as investors seek to arbitrage between the bond and loan markets.  One constraint is that such increased fixed rate buckets require increased fixed rate liabilities, which typically have a smaller investor base; however, Deutsche Bank is exploring solutions to bridge this. One such solution is a capped AAA tranche, that acts similarly to a fixed-rate tranche when factoring interest rate stresses. In a more benign environment, it would behave like a floating rate tranche, thereby providing some hedge to investors.

LIBOR versus SOFR

The transition from LIBOR to SOFR has been ‘relatively smooth’. The real issue would be re-pricing on refinancings and resets, especially given where this was at the end of Q4 2021. It was considered how no differential exists currently. Keeping abreast of the spot differential, especially with respect to any legacy deals is important.  LIBOR and SOFR respond differently (the latter being a risk-free reference rate), and thus one really needs to look at the underlying deal documents.

Value within the capital stack

BBBs have become a market-standard tranche, providing ‘quite a healthy cushion against any downgrade’.  From an equity investor’s perspective, last year was ‘amazing’, since great spreads could be locked-in.  Placing equity now is ‘tricky’ because the arbitrage is not there - ‘the math is challenging’ - and this is in addition to spreads on mezzanine being a ‘bit too wide’ to attract investors.  It was suggested that relative value is more of an issue now in the secondary market.

"It is sensible to find CLO managers who know how to trade, to extract value, and how to hold their nerve"
Conor O’Toole, Head of European Securitisation Research at Deutsche Bank

Trading

One of the key prongs of the success of CLOs is their actively managed nature.  Conor O’Toole, Managing Director and Head of European Securitisation Research at Deutsche Bank, made some observations regarding CLO manager selection.  Given the bumpy economic road ahead, O’Toole considered it sensible to find CLO managers who know how to trade, to extract value, and how to hold their nerve (not selling off when a market dislocation event happens in order to take losses early, and instead holding to preserve par).  A September 2021 study by Fitch into CLO performance throughout the pandemic confirmed that some managers were indeed trading away potential upside.¹ Panelists concurred with O’Toole and Fitch, adding that investment styles can play out differently- given that every market cycle is different, and that examining how a CLO manager had dealt with particular credits during problematic patches was a more effective exercise than crunching their high-level performance statistics.

EU regulatory brakes

There was discussion about whether the regulatory ‘brakes’ on the European market would in due course be removed to enable further growth of CLOs. These include:

• Retail investors not being able to fully access the leveraged loan market (if they could, financing would be cheaper); and
• Particular regions and sectors in Europe favouring CLOs more than others (if the appetite for CLOs were more pan-continental, one would have a deeper and more liquid market for parties to trade within).

Speakers agreed that environmental, social and governance (ESG) frameworks and investor appetite were impacting CLOs “at a pace”. Just as it has proved difficult for regulators and investors to pinpoint what is covered by the term ‘ESG’, so too has pinpointing the ambit and age of any of the structured products (and market awareness of them) that derive from the ESG concept. 

The EU’s Action Plan for Sustainable Finance has helped this, as have its accompanying efforts regarding areas such as green bonds, the Sustainable Finance Disclosure Regulation (SFDR),² and its Taxonomy Regulation.³ Industry-led initiatives are also helping clarify matters: for example, the European Leveraged Finance Association has produced 14 ESG sector-specific factsheets.⁴

While it was not technically possible for a CLO to be an SFDR ‘Article 8’ product, establishing what exactly counts as an ‘Article 8-aligned’ CLO was much less clear – although CLO managers are describing their products and active management approach as such.

It’s too early to tell whether ‘greenwashing’ was occurring in certain parts of the CLO market, a genuine desire to use finance to do the ‘right thing’ for the planet did come across from market participants.  Moreover, the topic is far from a novel one for the sector, given credit-related ESG factors have always been part of the analysis of building and managing a CLO, and negative screening of credits in certain sectors has long been market practice (said to be undertaken by 80–90% of CLO managers). 

What is new is the increased variation in definitions of ESG, which the industry is then whittling down to a widely agreed set of terms and standards.  In addition to agreement on a set of definitions and ratings around which market participants can coalesce, a robust “data supply chain” and use of third-party technology partners will also play a key part in how CLO managers keep on top of all this.  Panelists flagged that, for investors, comparability of data was key, but that this market was ‘just not there with ESG’ yet. 

Green bonds were noted to be often 100bps cheaper (an opportunity), and that if this carried over to loans then ESG compliance for underlying obligors would become far more important.  It would also be a ‘game changer’ in achieving the goal of green finance. Non-compliance would mean the cost of capital burden increases or the financing itself may be blocked. One note of caution was also sounded regarding negative screening.  The practice has been accepted as the starting point of all ‘green CLOs’ (from ‘light green CLOs’, which just undertake negative screening with the aim of being ‘sustainable’, or ‘dark green CLOs’, which are ‘consciously’ green).  However, the black-and-white nature of negative screening can remove from the investment universe corporates which, despite a ‘brown’ starting point, are on a value-adding ‘green trajectory’.  As Henrik Pontzen, Head of ESG at Germany’s Union Investment, once put it, “If a lousy company becomes better, the overall effect is greater than if someone who is almost perfect becomes a little bit better.” 

Too good to fail

The “compounding crises” of the current short-term headwinds such as Ukraine and market volatility do also provide opportunities.  Default rates are expected to pick-up from today’s historical lows, but a swathe of defaults is not anticipated

While some structured products did not survive the global financial crisis, CLOs have not only survived but thrived, adapting to satisfy all such stakeholder groups while renewing and expanding its investor base; as a study published by the Bank of England illustrates.⁵ Indeed, as one speaker put it, it is not a case of the CLO market being ‘too big to fail’, but rather that the product was ‘too good to fail’. 

The 9^th Annual Investors’ Conference on European CLOs and Leveraged Loans was held in London on 21 April 2022

Sources

¹ See https://bit.ly/3xSELWI at fitchratings.com
² See https://bit.ly/3bBP22k at eur-lex.europa.eu and https://bit.ly/3bAgVHZ at ec.europa.eu
³ See https://bit.ly/3OvCcRy at eur-lex.europa.eu and https://bit.ly/3OzjIQs at ec.europa.eu
⁴ See https://bit.ly/3NpW1bS at elfainvestors.com
⁵ See https://bit.ly/3xWFBC5 at bankofengland.co.uk