The European collateralized loan obligation market demonstrated a good degree of resilience in 2020, by not only working as advertised in the face of COVID-19, but also embarking on a path to normalization despite the threats posed by the pandemic having not yet subsided.
By Dec. 11, the European CLO market — the predominant investor segment in leveraged loans — had printed €22.1 billion from 66 deals in 2020, down from a record €29.82 billion and 72 deals in 2019, according to LCD.
The €22.1 billion notched in 2020 is the lowest full-year volume since 2017, but this is due to smaller issue sizes emerging in the wake of the pandemic. Indeed, the 66 deal count equals that of 2018, which is the second-largest annual deal count of the CLO 2.0 era, highlighting that activity remained relatively brisk despite the significant challenges faced by the market.
Of those new-issue CLO deals issued this year (to Dec. 7), 42 managers came to the market — including five from debut managers, and two which did not issue in 2019. However, of the 50 CLO managers that printed deals in 2019, 15 did not return to the market in 2020, according to LCD, and it remains to be seen if this pattern leads to manager consolidation becoming a theme in 2021. Certainly, market participants say the scene is set for some consolidation to take place, but others question how beneficial it is for a platform to buy another manager's portfolios, which have a different style, or suggest they could use the money to raise their own larger risk-retention fund instead.
Activity during the early months of the pandemic comprised the terming out of pre-COVID-19 CLO warehouses, characterized by their smaller sizes, lower leverage and shorter non-call and reinvestment periods, which gave managers the option of refinancing or resetting next year when conditions improve. Indeed, resets are expected to be a firm feature of 2021's European CLO market activity.
However, the market has since shown clear signs of normalizing, driven by robust demand for CLO paper which has pushed liability spreads tighter, and gradually improved the arbitrage — essentially the spread differential between a CLO's assets and liabilities — for new deal creation.
Now at the end of the year, European CLO deal sizes have crept up, single-B tranches have long returned, and four-year reinvestment periods are becoming more commonplace, all of which sets the scene for 2021.
Drivers to the upside:
Tightening liabilities. The weighted average cost of capital for new-issue CLOs has tightened from an average of 243 basis points in Q2'20 to 201 bps in the three months to Dec. 7. Meanwhile, triple-A spreads tightened from 172 bps to 111 bps on average for the same time periods. Anecdotally, market participants expect this tightening to continue into Q1'21, with some expecting to see deals print at 95 bps or lower at the top of the stack by as early as January. Analysts at Barclays forecast generic primary spreads (from top-tier managers from longer-duration deals) to tighten by up to 25 bps on triple-As, up to 15 bps on double-As, up to 30 bps on both single-As and triple-Bs, up to 70 bps on double-Bs, and up to 75 bps on single-Bs. A crucial tailwind will be how attractive CLOs' investment-grade paper remains versus other asset classes going into 2021. Added to the fact they are floored, CLO notes are still seen as offering good relative value versus other structured finance products.
A more positive loan pipeline. CLO managers are being told to expect a strong Q1'21 pipeline for primary loans, with banks' appetite for risk said to be picking up, while private equity players strike an optimistic tone. This sentiment is supported by early forecasts for primary issuance in the European leveraged loan market, which point to a return to 2019 levels. For example, Barclays estimates net leveraged loan supply of €23 billion and gross supply of €75 billion, while J.P. Morgan forecasts €30 billion of net supply and €65 billion of gross supply.
CLO credit performance has held up. Despite an avalanche of negative ratings actions, European CLOs have performed well during the COVID-19 pandemic, or rather, they have "worked as advertised." "Despite WARF and CCC tests breaches in, respectively, c. 90% and 40% of deals, OC breaches were few and far between: no debt tranche has PIK-ed so far and equity cash flow disruptions (i.e. junior OC breaches) peaked at just 4% of deals in July," write analysts at BofA Research. While further downgrades are expected to take place, the consensus from CLO managers is that the worst is over, and that COVID-19 risk is now better understood by managers and liability investors alike.
Demand for equity is picking up. While equity is still thought to be more attractive in the secondary market than it is in the primary market, a handful of deals toward the end of the year are understood to have attracted significant interest from minority equity, while some managers have spoken of being able to raise external warehouse first-loss equity for new deals.
Arrangers are open for business. There has been increasing competition among arrangers to open new warehouses toward the end of 2020, which has improved terms for managers. Early in the pandemic, the handful of arrangers that were extending new warehouses offered mark-to-market warehouses with tighter advance rates, tests and trading restrictions. Now the terms on offer are understood to be broadly comparable to pre-COVID-19 offerings, and for some managers they are said to be more aggressive, while Jefferies has added to the list of arrangers vying for business in Europe.
Flexibility to hold distressed assets. One of the most significant innovations in the European CLO market this year has been the inclusion of language to allow managers greater flexibility to continue to hold assets in the event of a restructuring. Loss-mitigation loan and workout loan language first appeared in European CLO deals in the summer, and are now a market staple. Managers and liability investors alike have viewed the development as a positive, in that by design they avoid CLOs becoming forced sellers.
Defaults to be contained. European corporate defaults have remained low in 2020, while any rise in the near term is expected to be contained. Although there is a disparity in forecasts (see below), some point to benign default rates. At the lower end of the estimates, J.P. Morgan forecasts that default rates will climb in the very near term to 4%, before subsiding over the second half of the year for a 2021 default rate of just 2%.
More positive macroeconomic picture. Coronavirus risk is now better understood, while the development and rollout of vaccines and prevailing central bank support creates a more favorable platform for issuance, managers argue.
Drivers to the downside:
Loans, loans, loans. New assets are vital for those seeking to ramp, and following a year during which assets were in short supply, being able to ramp with decent-quality, attractively-priced collateral remains the biggest concern for managers. Despite forecasts that loan volume will pick up, managers consulted expect not just to see an increase in much-needed M&A activity, but also opportunistic transactions.
Repricings likely. The return of loan repricings is of particular concern, while new loans done in Q2'20 or Q3'20 will be on the chopping block once their non-call periods run off, putting pressure on an already challenged CLO arbitrage.
Asset yields are tightening quicker than liabilities. Tightening loan spreads have made ramping trickier for CLOs that launched toward the end of 2020, and will make building a portfolio costlier should this situation continue into 2021. Anecdotally, managers have noted that the weighted average purchase price — or the cost of buying assets — tightened from 98.5 in November, to 99.25-99.50 at the beginning of December. Furthermore, a number of managers concur that it is likely to cost roughly 99.75 to ramp during the first quarter of 2021. On top of that the weighted average spread has tightened on new primary loan deals, with some managers in December noting that loan spreads had returned to January 2020 levels, and like-for-like to where they were 2019.
The expected return of CLO refinancings and resets. A spike of CLOs coming out of their non-call periods, which was inflated by the printing of short-duration vehicles this year — there were 46 non-call for one-year deals totaling €14 billion, according to LCD — are expected to provide an uptick in CLO refinancings and resets, should liabilities continue to tighten. This dynamic will gobble up demand for liabilities, and therefore prevent them from tightening much more for primary issuance.
Open warehouses down year on year. Despite competition from arrangers picking up toward the end of 2020, there are expected to be 15-20 less warehouses open going into the first quarter of 2021 versus the beginning of this year. At the end of November, analysts at Deutsche Bank put the number of open warehouses in a high-30s to low-40s context, down from their estimate in the high-50s at the beginning of 2020. While the market had done a good job at securitizing outstanding warehouses, new warehouse creation has been dampened by less supply in warehouse first-loss equity and a general reluctance, until recently, to open more warehouses, arrangers note.
Third-party equity is still a challenge. While warehouse terms are back to pre-COVID levels or better, the biggest issue is still finding first-loss money, with the challenge of attracting third-party equity remaining the major sticking point for managers without internal capital or risk-retention funds. The arbitrage has improved, with some managers expecting to see a potential bifurcation between those more able to source first-loss for warehouses and others that continue to struggle. Nevertheless, activity in the near term is expected to remain dominated by those able to do their own equity, or a significant chunk of it.
Default expectations differ. The flipside to the above perception that European corporate default rates are expected to be contained is that they are nevertheless still likely to rise, while an imminent uptick in unemployment could mean such rates are higher than expected. At the other end of projections, S&P Global Ratings forecasts a near doubling in the default rate next year, to 8% by September 2021.
All the good news has already been priced in. With asset prices having accelerated toward pre-pandemic levels while in the midst of a pandemic, it could be argued that the rally may have peaked or even gone too far, considering many companies now have a higher debt burden as a result of the crisis. The market could still be susceptible to uncomfortable bouts of volatility should rising COVID-19 infections and new lockdown restrictions come into play, or if vaccines fall short of being effective enough to have a significant positive impact in the near term.
New CLO issuance volume is expected to increase in 2021 alongside the return of refinancings and resets, according to early forecasts. Analysts at Barclays forecast €25 billion to €30 billion of primary CLO supply next year and €10 billion to €15 billion of refinancings and resets, while Deutsche Bank is expecting €25 billion of new-issue supply and €25 billion/€15 billion of refis/resets in its base case. In addition, both J.P. Morgan and BNP Paribas expect new-issue CLO supply to reach €25 billion, while BofA Securities forecasts €24 billion of gross CLO issuance and €7 billion to €15 billion of refinancing activity.