Following the busiest quarter on record for new issues, resets and refinancings combined, the cumulative weight of issuance absorbed by the European CLO market has exerted upward pressure on liability spreads, most notably at the top of the capital stack.
As such, participants note that the market is currently in price discovery mode, with spreads for triple-A notes on new-issue deals over the past month having widened to the mid-to-high 80s (basis points), while the market has most recently gapped out to what sources expect to be a low-to-mid 90s context.
While CLO triple-A spreads remain tight on a historical basis, it remains to be seen what impact further widening would have on issuance, with some CLO resets and refinancings likely to make less economic sense for managers. However, there remains plenty of wood left to chop in regards to resets of less price-sensitive deals dating from 2020, which some believe could crowd out new CLO issues, while on the new-issue front the asset side is supported by an encouraging loan pipeline.
As the close of the second quarter approaches, it is unlikely that European CLO issuance will match the €19.61 billion combined total of new issues, resets and refinancings recorded in the first quarter of 2021.
Nevertheless, the second quarter of 2021 is already set to be the second-busiest on record in Europe for new issues, resets and refinancings combined, with a total of €11.65 billion having priced in the period as of June 1. For the second quarter in a row, resets have made up the bulk of volume at €8.42 billion during the period, versus €11.11 billion in the first quarter, while new issuance for the second quarter stands at €4.66 billion from 11 deals (again to June 1), versus €7.81 billion from 20 deals in the first quarter.
Activity cooled off somewhat in May, which ranks as the second-quietest month of the year for European CLOs with four new-issue deals pricing, mostly toward the tail end of the month. However, a total of 30 managers have already cleared the market with new-issue deals so far this year, which is just 13 shy of the total number of managers to come to market in the whole of 2020.
While the depth of the investor base led to a compression in CLO spreads in the first quarter of 2021, the resulting spike in supply has caused a softening in spreads as the second quarter enters its final leg, with some investors having stepped back after heavy participation at the start of the year. The glut of CLO resets to come to the market is a major factor here. However, market participants also point to the relative-value play versus the U.S. CLO product, with sources noting that the U.S. market remains more attractive for those investors who play on both sides of the Atlantic.
"In Europe, if triple-A spreads are in the low-to-mid 80s, even with the floor, it isn't as attractive as the U.S., where triple-A spreads are in the range of 115-low 120s," commented one CLO manager.
On the new-issue front, pricing at the top of the stack on recent prints has come in 11 basis points north of the market tights set in March, which culminated in Sound Point Euro CLO V Funding pricing with a triple-A spread of 77 bps.
Prior to the pricing of the €304.65 million Sculptor European CLO VIII and the €405.9 million Bain Capital Euro 2021-1 CLO, which both came in at 88 bps, a new-issue European deal had not printed with a triple-A spread north of 85 bps since early February, according to LCD, despite pricing inching wider since late April, and resets (which price at a premium to new issues) trending toward the high-80s.
"While the prolonged post-pandemic rally seems to be coming to an end, the magnitude of the widening looks modest compared to the impressive supply in the primary. That suggests a bullish stance and a strong investor base on the top of the stack along with attractive relative value in the general search for yield. Low AAA spread tiering also reinforces this view," wrote analysts at BofA Securities in a research report published June 7.
Market participants over the past month have concurred that the mezzanine bid has remained strong as triple-As have widened. However, the double-B and single-B spreads on both the last two new-issue deals also came in wider than recent prints, pointing to a potential softening lower down the stack. In particular, the 950 bps single-B discount margin on Bain Capital Euro 2021-1 CLO is the widest for a new-issue print this year, according to LCD data.
However, market sources comment that mezzanine tranches remain well supported, and that this softening is not expected to be indicative of a longer-term trend.
Instead of being structured as traditional CLO notes, some deal tranches are structured in a loan format for certain investors (who receive better capital treatment for holding CLO exposure in this format). Since this structuring tool emerged in February this year in Europe, €2.57 billion of triple-A exposure has now been taken down in loan format across both new issues and resets, the lion's share of which priced in March and April. Since then though, loan tranches have seldom featured, with Sculptor European CLO VIII ranking as the only deal in May to include such a tranche.
"One could begin to think there is room for this type of issuance to grow further from here. However ultimately we anticipate the scope for such growth will be curtailed given the regulatory benefit — more favorable M2M accounting treatment under U.S. GAAP — will be limited to only a handful of AAA account buyers," wrote analysts at Deutsche Bank in a research note published June 4.
While further price widening at the top of the stack would likely impact the viability of certain CLOs being able to refinance or reset, it remains to be seen what the effect would be regarding the timing of new issuance. One CLO manager commented that loan spreads need to be at 385 bps to make current liability spreads work, which has in turn led to a scramble for the remaining COVID-19-exposed discounted names in the European secondary loan market, sending credits in travel and leisure sectors higher by up to 5 points in some cases over the past month.
According to LCD data, primary loan pricing would appear to broadly support this level, with loans having generally trended wider in tandem with CLO spreads of late. The average single-B rated term loan B spread widened to 385 bps in the second quarter from 382 bps in the first quarter, while the average CLO weighted cost of capital increased to 169 bps from 166.7 bps — thereby suggesting the 200 bps of excess spread is still there, at least on paper.
With roughly eight weeks remaining until the traditional late-summer break for CLOs and leveraged finance, some are gearing up for a busy period of issuance in the run up to that hiatus. Upwards of 50 CLO warehouses are understood to be open, and while not all are expected to come to the market this year, many managers have spoken of their confidence in being able to ramp comfortably in the European primary loan market so far, with liability spreads the prevailing factor in terms of timing (the European CLO market is the predominant investor segment in leveraged loans).
Should spreads widen further, sources note, the impact is likely to play out for the most part on resets and refinancings of pre-2020 vehicles. "If they gap wider, then resets will slow down and the market becomes all about new issues," commented one CLO manager.
Regardless of where spreads go, resets of 2020 vehicles are expected to make up a hearty chunk of issuance in the run up to the summer. These deals, which priced last year with a one-year non-call period, are far less price-sensitive given the eye-watering spreads that were locked in following the onset of the pandemic.
"The majority of non-calls end before the end of August this year, so we expect issuance will be heavy from the second part of June to July," concludes another CLO manager. "You could expect new issues to wait as a result."