The European collateralized loan obligation market has shown encouraging signs that it has normalized to some extent, as it emerges from the busiest month for new issuance since July 2019, buoyed by improving economics for CLO managers.

However, with just over a month of potential issuance remaining before year-end, it remains to be seen where liabilities further down the CLO stack will shake out, following a slight widening toward the end of October. Furthermore, new warehouse creation and the prevailing difficulty of attracting third-party equity in the face of low European leveraged loan issuance remain longer-term challenges.

The European CLO market, the predominant investor segment in leveraged loans, has priced €18.7 billion from 56 transactions so far this year (to Nov. 11) from 38 managers, including €12.9 billion from 42 COVID-19-era prints (from April onward), according to LCD.

In October alone, some €4 billion from 12 deals priced, in what amounted to a crowded primary CLO market. Indeed, roughly half of the month's supply — €1.9 billion from six deals —priced within a week from Oct. 22, as the U.S. presidential election loomed in early November.

This flurry of issuance was set against tightening liabilities for CLO managers, which saw triple-A spreads grind in to 110 basis points, a level first set by Barings Euro CLO 2020-1 and CVC Cordatus Loan Fund XVIII in late September, with eight deals now having printed at that level.

This represents a dramatic shift from a few months prior, where 145 bps remained the benchmark-low for triple-A spreads throughout July and August.

At the 110 bps level for triple-A spreads, market participants have noted that the arbitrage — essentially the spread differential between a CLO's assets and liabilities — is now more appealing. "Coupons have tightened such that the arb looks OK and is back to where it was in summer 2019," remarked one CLO manager, cautioning that placing equity remains a challenge.

As a back-of-the-envelope comparison, the weighted average cost of capital, or WACC, for deals priced in the three months to October was 202 bps, while the average spread for single-B rated term loans was 444 bps, according to LCD, equating to an average excess spread of 242 bps. This compares to an average WACC of 195 bps and an average single-B term loan spread of 397 bps in Q3'19, and an average excess spread of 203 bps. The rule of thumb for an attractively functioning arbitrage is 200 bps of excess spread, and the current 241 bps was last bettered in Q1'18.

These figures are averages, however, and the real problem for CLO managers has been a lack of European leveraged loan issuance at these levels. There simply have not been enough leveraged loan new issues to take advantage of the higher spreads, leaving managers at the mercy of secondary markets, where prices have largely rallied close to pre-COVID-19 levels.

Crocodile tiers
While the pandemic has laid bare manager performance in the face of pronounced volatility, manager tiering — whereby the cost of raising a new CLO, namely liability costs, can vary depending on the experience of the manager — has yet to demonstrably filter through to triple-A spreads in Europe as it has done in the U.S., with only a small degree of pricing variance observed at the top of the stack.

Of those CLOs that priced north of 110 bps toward the end of October, market participants commented that this was more of a supply and demand issue. "Sometimes you are unlucky in timing, and you would need a hurricane of defaults before triple-As are at risk," commented one CLO note investor. "Triple-As are viewed almost like mortgage bonds."

There is a greater argument for manager tiering further down the stack though, where there has been more volatility in recent weeks and evidence of CLO spreads widening. However, sources note that the variance observed has, in large part, also been a result of indigestion from a busy primary CLO market.

Triple-B spreads on CLO prints in October came in wider than those priced in previous months. For example, the triple-B notes on Sculptor European CLO VII, Hayfin Emerald CLO V and Sound Point Euro CLO IV all came at 450 bps, versus lows of 350 bps in September, and average triple-B pricing of roughly 420 bps in October. The last time a triple-B print came at 450 bps or above was July.

In addition, Palmer Square's second 'static' European CLO (there is no reinvestment period), which priced on Oct. 23 at 87 bps across the triple-As, firmed at 435 bps across the triple-B notes, which is higher than most triple-B spreads seen in recent reinvestment CLOs. Static CLOs typically price much tighter than reinvestment CLOs, owing to their shorter duration and need for a more conservative portfolio, as these vehicles are not actively managed.

Market participants commented that the hike in CLO triple-B spreads could also be attributed to a lack of buyers at that level towards the end of October, with one considerable investor in triple-Bs said to have taken a back seat towards the end of the month, highlighting the shallow pool of investors at that level. "The triple-B buyer base seemed to be a lot more picky on levels, and arrangers took time to catch up with that expectation," said one liability investor. "If you were offered price talk at 410 bps, there were enough deals in the market that you could say 'I'm not interested', and look at the next deal."

Low ramp
Anecdotally, market participants agree that at least some of the recent crop of CLO deals were lower-ramped at pricing than usual, a trend exacerbated by a slow European primary loan calendar in recent months. At the extreme end of the spectrum was the €354.1 million Fair Oaks Loan Funding III CLO for Fair Oaks Capital, a 'print-and-sprint' deal that priced without a pre-pricing warehouse.

With secondary loans now perceived to be offering very little value, ramping is not without its challenges, but managers appear bullish on their ability to ramp quickly post-pricing. "In reality, the market is deep and liquid enough to ramp," commented one CLO manager. "If you have a low ramp but liabilities are there, then you print," the source added.

Another manager highlighted there is added flexibility in what they can buy once a deal prices, adding that warehouses were more restrictive in terms of what assets could be purchased, with some excluding bonds or lower-rated deals.

While pricing has tightened in the direction of pre-pandemic levels, the European market has so far retained its shorter structure in terms of tenor, with one-year non-call and three-year reinvestment periods prevailing — thereby contrasting with developments in the U.S. market, where five-year reinvestment periods are now featuring more frequently.

In Europe, Sound Point's €340.2 million Euro CLO IV carried the longest reinvestment period for a 110 bps triple-A print since the COVID-19 pandemic hit, at 3.5 years (ending July 2024).

"Everyone is unsure of where the market will go," said one CLO manager. "You need to have the option to reset/refi in a year's time, but you also need to consider how your deal looks if that doesn't happen."

Back to the future
Consensus estimates put the expected number of CLOs set to price before year-end at between five and seven, with more optimistic expectations at around the ten-deal mark. However, given the prevailing uncertainty, this figure could well shake out lower should some managers opt to wait until 2021 to price. "From an investor's point of view, there's a lot in favor of doing as little as possible," commented one CLO note investor, adding that some investors may adopt a wait-and-see approach in December.

One market estimate puts the number of warehouses currently open at around 36, a figure which includes the 12-14 warehouses said to have opened since the onset of the pandemic. One arranger alone is understood to currently have 12 warehouses open.

Anecdotally, the case for new warehouse creation is said to have improved considerably since the onset of the pandemic, and there are plenty of factors which could support the expectation that new warehouse creation may pick up.

Certainly, warehouse terms have been steadily improving since the onset of the COVID-19 crisis. "I don't think warehouse terms are dramatically different to pre-crisis terms now, although banks need a bigger first-loss and increased advance rates," noted a CLO manager, while the number of banks seeking to put risk on is understood to be greater today than it was a few months ago.

A thin European loan pipeline and arrangers seeking greater protection from market volatility by asking for a larger first-loss piece — something managers don't generally want — are considered two of the many reasons why the market has yet to see a flurry of new warehouse creation.

However, one arranger said they expect a flurry of new warehouses to open up before the end of the year, in anticipation of a busier Q1’21 loan pipeline, but cautioned there was a balance between inserting enough protection for warehouse providers, versus making sure enough warehouses are open to generate sufficient business.

Third-party policy
Generating increased third-party equity demand remains one of the biggest hurdles for managers to clear, however, and while CLO liabilities are currently more attractive, the question remains whether managers, particularly those seeking third-party warehouse equity, will be able to provide comfort to prospective equity providers that they will get the right return. As a result, new warehouse creation is likely to be dominated by those players with internal capital or risk-retention funds.

Nevertheless, the European CLO market has surprised to the upside during the pandemic so far, and it could reasonably be assumed that the market will perform even better in more sanguine times. Indeed, indicative forecasts point to a busier 2021 (on November 8, analysts at J.P. Morgan forecast new European CLO supply of €25 billion in 2021).

While the market continues to try to normalize, average CLO new-issue sizes remain considerably lower than they were before the pandemic. The 56 deals to price this year so far total €18.7 billion, compared to 67 deals totaling €27.8 billion priced in the same period in 2019. It is therefore reasonable to expect any increase in 2021 to result from a combination of a higher deal count and a normalization of CLO issue sizes.

The road ahead is likely to remain dominated by COVID-19 for some time yet, though Pfizer Inc.'s announcement this week that it has created a vaccine with 90% efficacy could well provide support for the higher CLO issuance that this market's participants are hoping for.