Falling liability spreads, which have tightened quicker and deeper than most expected, are proving the catalyst for a strong start to the year for European collateralized loan obligation new issues, as well as resets and refinancings.
Through the end of February this year, the European CLO market, the predominant investor segment in leveraged loans, had priced €4.56 billion from 12 new issues, including €1.47 billion from four managers — Anchorage Capital Group, Oak Hill Advisors, Assured Investment Management and Commerzbank — that sat out 2020.
This tracks broadly in line with issuance early in 2020. Last year, new issuance totaled €4.6 billion from 11 deals prior to the COVID-19 related sell-off in early March 2020. Average sizes are still currently marginally lower this year than they were during this period last year, at €380 million versus €419 million, respectively.
However, less than a year after the market first switched to shorter-duration vehicles, structures on new-issue CLOs are trending ever closer to the pre-COVID norm of a two-year non-call and 4.5-year reinvestment period, with 1.5-years/4.5-years observed on recent prints, while liability spreads are now tighter than they were in the run-up to the pandemic.
Indeed, triple-A spreads on new-issue deals averaged 84.5 bps during the first two months of 2021, compared to 92 bps at the beginning of 2020. Moreover, triple-A spreads are expected to grind still tighter in the near term.
It is this compression in liability spreads that continues to improve reset and refinancing prospects, with €5.64 billion from 13 resets and €5.11 billion from 16 refinancings having priced as of the end of February. On volume alone, there has been broadly the same volume of refis and resets in January and February as in the preceding six calendar quarters combined, the largest calendar quarter volume on record in the 2.0 era.
The return of Japanese investors — albeit not Norinchuken — as well as bank treasuries, has deepened the triple-A pool of liquidity, providing a clear tailwind for managers, especially those with well-ramped warehouses.
As well as a deeper bid, the current tightening bias also stems from CLOs being attractive on a relative-value basis, boosted by the value of their Euribor floors.
As a result, multiple oversubscriptions have been heralded by those managers who have printed thus far. Manager tiering at the top of the stack, though, remains strictly a U.S. feature, with very little variation across triple-A notes from one CLO to another in Europe, and debut issuers — namely Neuberger Berman — attracting sub-90 bps pricing.
With the pace and depth of liability spread tightening exceeding most expectations, some market participants expect that the spread compression will eventually extend to establish new post-Global-Financial-Crisis tights.
Indeed, the €409.4 million Sound Point Euro CLO V Funding for Sound Point set a new pandemic-era benchmark low for triple-A spreads on March 10, at 77 bps, while LCD has spoken to some that expect spreads could eventually move inside record tights, such as the demand for yield. The tightest print for a European 2.0 CLO triple-A tranche is 68 bps, which was achieved in 2018, according to LCD.
This view is supported by a Barclays research note published on Feb. 19, commenting that while another 20 bps of triple-A spread tightening would be difficult to envisage (spreads are currently more than 25 bps tighter than the 105 bps benchmark low in December), negative rates and sluggish loan supply could well spur triple-A spreads to reach new levels in Europe.
"We see a higher probability for European AAAs to tighten past post-GFC tights, though, at least into Q2 before supply weighs on demand. This is due to the prevalence of negative rates in Europe, potential headwinds in sourcing collateral and creating a drag on new CLO supply in the short term, and a higher embedded Euribor floor benefit than in years past, improving all-in spreads," analysts at the bank wrote.
One development that some in the market expect to act as a force for further pricing compression is the emergence of loan notes in the CLO structure, which first featured in the €410 million Providus CLO V for Permira European CLO Manager.
A €50 million portion of the class A tranche on that deal was structured as a loan, ranking pari-passu with the class A notes, which sources comment was driven by an investor preferring to have their exposure in a loan — rather than a bond — format.
The inclusion of the class A loan is understood to be a structuring feature likely not seen before in the new generation of European CLOs, which some expect could attract new investors to the market that would receive better capital treatment by holding a loan versus a floating bond.
WACC this way
Loan spreads continue to chase liability spreads tighter. As a back-of-the-envelope comparison, the weighted average cost of capital, or WACC, for new-issue CLOs that priced in the first two months of 2021 was 169.17 bps, while the average spread for single-B rated term loans was 380 bps, according to LCD, equating to an average excess spread of 211 bps.
This compares to an average WACC of 201 bps and an average single-B term loan spread of 412 bps in the fourth quarter of 2020, totaling an almost identical excess spread of 211 bps. The rule of thumb for an attractively functioning arbitrage is 200 bps of excess spread.
However, with conditions increasingly tight on the asset side, a growing number of market participants expect that European CLO new issuance could slow down in the short term, as managers potentially favor a slower ramp strategy.
Managers comment that investors prefer to see more heavily ramped portfolios, in order to allay concerns over the current ability to find attractively priced assets quickly. This is evidenced by the higher ramp levels, in some cases in excess of 70%, on those deals to have priced already this year.
This is exacerbated by a rallying secondary loan market. In February, the weighted average bid of the S&P European Leveraged Loan Index, or ELLI, climbed back above its pre-pandemic high of 98.66 set in January 2020, to end the month at 98.68. At current levels, secondary loan prices are understood to make for a trickier ramp, which has driven attention to the primary market, which has been awash with reverse-flexes.
Higher secondary loan prices and the strong oversubscription attracted in primary loan markets serve to further the case for a slower ramp. "There has been a lot of scale back in the loans that we have done," commented one CLO manager, while a second manager said that they wouldn't want to price a deal at a 40% ramp in the current market, adding that it would be difficult to price two-to-three CLOs in the European market this year, and that one-to-two deals would be more feasible. Conversely, one liability investor consulted said that they would consider a deal with a 40% ramp, so long as the manager could provide sufficient clarity on what they were going to buy.
While there has been clear downward pressure on loan spreads, some comment that in recent weeks a brick wall at 350 bps for B2 credits is emerging, with CLOs seemingly unwilling to go tighter on a number of deals. However, questions remain over how long this might last, with downward pressure expected to build as more managers drive down their cost of capital on existing deals.
Reset versus refi
Nevertheless, refinancings and resets are expected to remain the key focus in the near term. So far this year, four vehicles have reset with triple-A notes that have priced at 79 bps for a reinvestment period extension of four or more years.
For those deals where the refinancing route has proven more attractive to equity investors than extending the life of the transaction, pricing on the upper-most rated notes has tightened to 60 bps for both vehicles whose reinvestment period runs off this year and next.
Thus far, a higher number of pre-2020 vehicles have taken the refinancing route. However, as the year progresses, those deals that priced with small sizes and one-year non-call periods will become ready for resets and certainly upsizes. The first notices from European CLO managers seeking to reset or refinance deals that priced in 2020 began to filter through last week, with LCD counting three such filings — for Permira, KKR Credit Advisors and CVC Credit Partners — on Euronext Dublin during the week commencing March 1.
Overall, the extent to which liability spreads have tightened has already moved the needle to encompass more potential targets. Analysts at BofA Securities have already updated their forecast to adjust for the spread tightening since the beginning of January and the number of deals coming out of their non-call periods this year. BofA Securities now expects the refinancings and resets total to come in at €30 billion-€40 billion this year, versus its previous forecast of €7 billion-€15 billion.
Nomura also revised its forecast for CLO refinancings, with analysts at the bank now anticipating refinancing volume for the year to total €65 billion, up from roughly €40 billion, which suggests that around 50% of the outstanding CLO tranches that are callable in 2021 will be refinanced.
One advantage of opting for a reset is that it is easier to implement the workout language that emerged in the European market in August last year, while LCD has spoken to managers who are looking to do just that.
Indeed, importing loss mitigation loan/workout loan language into old documentation without doing a reset is understood to be a tricky feat, as it requires consent from noteholders dominated by triple-A investors who, considering their position in the capital stack, are not necessarily incentivized to consent to the new language.
Further, the refinancing and reset wave has allowed managers a more cost efficient route to roll in Moody's new methodology for calculating WARF.
For those CLOs that are not on the immediate chopping block for a reset, the ability to import this language into old documentation varies from vehicle to vehicle, with the trickiest of those again requiring consent from controlling classes. The reward, however, is greater flexibility, with managers speaking of gaining 250-300 extra points of WARF after adopting the new language.