1. Calls and amortisation keep CLO technicals strong

CLO call volume and amortisation has led to a strong technical backdrop in the market, with investors keen to redeploy and stay invested after receiving principal back

The huge amount of CLO amortisation comes from the fact issuers are extending loans, which means many older post-reinvestment CLOs are struggling to stay invested. Amortisation looks likely to continue into July and October payment dates.

CLO liabilities have tightened since January, but triple-As have lagged slightly, given the strong technicals. In January, triple-A spreads were Euribor+150bps with the benchmark now at E+141bps.

Attendees believed further tightening will occur.

In an audience poll, 67% predicted triple-As spreads will tighten to E+130-140bps by July. Panellists agreed with this sentiment, adding that CLOs are lagging other structured products.

There may however be some widening out further down the capital structure in the triple-Bs and double-Bs, given idiosyncratic risks such as Altice.

CLO issuance will likely continue at a similar pace in the second half of 2024, with new issues and resets likely to be pursued as CLO equity investors seek to capture tight spreads for the next five years.

Limiting factors for CLO issuance include time constraints and the need to balance new issuance and reset activity.

2. Resets, but keep an eye on tail risks

European CLO reset volumes looks set to grow, with many deals coming out of their non-call period especially around Q3. Reset and refi volumes, however, will be less than the US market, given the comparatively weaker spread compression in Europe

And while some deals may be less viable from an economic point of view, managers may look at resets as a way to restart the reinvestment period, reset tests in deals and clean up portfolios, using the assets in a new warehouse to upsize the deals.

Partial refinancing volumes may also pick up, though this will largely be for a small cohort of deals which priced around Q1 and Q2 2022. These deals had tight triple-As, but slightly wider mezzanine tranches.

Investors however need look through to portfolios and understand underlying risks.

3. Loan levels key in determining CLO volumes

While CLO liabilities tightening may point to higher volumes (funding costs are at similar levels to 2021), the asset side of the equation will probably determine whether this will be a record year, or not.

The balance has shifted and now the pendulum has swung in favour of loan issuers, driven by spread tightening. And while there has been green shoots of M&A, there still remains a big question mark on valuations.

The good news is that some of the repricing is happening from private credit into public markets. This classifies as another form of ‘new issue’ for the loan market. And while the net new supply isn't amazing, it's sufficient to build diversified portfolios on a scale. That is reflected in year to date CLO creation

In addition, if net issuance remains relatively flat due to amortisation, the market doesn’t necessarily need a huge amount of new level of creation to sustain its current pace. Instead, managers can (and are) recycling loans from older CLOs into newer CLOs.

Still, the CLO arbitrage remains somewhat stretched for both repricing and some new issue deals with European B3 loans now pricing around E+375bps and some at E+350bps. The cost of debt for CLOs is somewhere in the region of E+230bps.

That spread pressure however is more meaningful for portfolio vintages that priced when markets were wide and when you had significant discounts.

35% of CLOs are post-reinvestment and facing difficulty reinvesting prepayments, but fundamentals are strong with defaults forecasted to reach the high 3% to 4% range by the end of the year,

4. Pressurised loan sectors

Around half of the expected 4% default rate will take the form of distressed debt exchanges, which panellists noted have “quite good” recoveries. Add to that, one panellist noted the market is likely past the peak for defaults.

But one thing is clear. The European CLO market is increasingly exposed to the top 20 obligors, which total around €32.8bn (though of course, at an individual CLO level, these are capped usually around 3% to the top three obligors). The top 20, with the exception of Altice, are largely highly rated (on average single-B rated). Most of these will mature in 2028.

Chemicals, real estate and healthcare were cited as sectors to keep an eye out for.

While the sector is cyclical, chemicals might be reaching an inflection point. The sector is, however, “a little bit precarious, with earnings far from peak”.

One panellist viewed real estate home builders earnings as “very, very bad and the cycle is still ongoing and still downsizing.” He added: “this is not really reflected in loan prices and we are trying to shy away from anything production related in real estate that doesn't have a near term catalyst”.

However, the panellist noted they did like the distribution part of real estate. “The counter cyclical nature of cash flows here gives good downside protection”.

While healthcare is around 20% of the market, inflationary pressures persist, particularly in the service sector (including care and nursing homes). “Once you've awarded your nurses a 7-9% pay increase, one or two years down the line those employees are not likely to accept that pay cut just because inflation has started to come down,” said a panellist.

On the flip side, finance, and especially trading house in the US, have been “posting phenomenal earnings more recently”.

5. CLO managers turn conservative as tests come into play

Conservative CLO managers have stuck to their approach. But managers that are considered to be opportunistic have drifted towards becoming more conservative, one panelist said.

CLOs are increasingly constrained by legal final maturity. “Issuers are less inclined to be flexible and accommodating with offering short extensions and accommodate their existing syndicate,” said one panellist. “I think issuers these days are looking for regular way extension trades, maybe new deals, maybe looking for 2031 type maturities. That obviously is not going to be something that works in an old CLO”

Concentration limits are also getting tested.

“Typically we’ve used high quality issuers with relatively short maturities to ‘barbell’ and keep the reinvestment going,” said one panellist. “As these transactions extend you can reduce some of the exposures and try to rebuild some of the room in the top 10 in your obligor test.” However this is becoming more difficult.

The focus on tail risk has led some to believe spread compression between higher quality and lower quality managers in junior mezz is concerning.

“When you look at two quality managers three years ago, their paper was trading 100bps away from each other on a new issue,” said a panellist. “Right now, they are about 30-40bps away from each other.”

While there may be a lack of differentiation by spread, one panellist argued CLO documentation and structures can vary a fair amount with some deals running lower WARF portfolios and tighter post-reinvestment language.

6. Lender-on-lender violence — a lawyer’s game

Panellists expressed concern around lender-on-lender violence and liability management exercises starting to seep into the European market from the US. Notable examples include Genesis Care, where value can be extracted readily from existing par lenders with material parts of the business designated as an unrestricted subsidiary

Newer post-2020 language in CLOs equip managers with the ability to manage situations and put up money in the form of loss mitigation loans and bankruptcy exchanges

It’s also never been clearer that this is a relationship-driven market, with one panelist saying they are cognisant of risks that can be involved with lending money to people who have a single asset that they will defend at all costs.

Still, while it is an issuer-friendly market, this is mostly being solved for with price, rather than documentation. “Documentation is a lawyer’s game” said one panellist.

7. Strong warehouses and no longer BYOE (bring your own equity)

CLO warehouse creation has remained strong over the past few months with banks offering “attractive warehouse terms”. 9fin reported earlier today on the strong warehouse activity in Europe, with 17 warehouses opened in May. That’s the highest volume of warehouses opened since 2022.

Building large portfolios in secondary markets today, however, does not work for a sustainable arbitrage, so warehouses are taking a little bit longer to ramp

The return of third-party equity investors was welcomed. Captive equity distributions were more prevalent last year, with 85% of issuance driven by BYOE, but one panellist predicted a 50/50 split between captive and third-party equity investments going forward. To have more participation from third-party CLO equity investors, the market needs tighter triple-As, however.

The good thing, they said, is that there is higher secondary activity for CLO equity, which has led to clear price discovery, while historic performance and historic distributions are also attracting some interest in the product (equity payments were suffering due to rate mismatch, but are now benefiting from rising rates).

8. CLOs innovate as concerning clauses creep in docs

CLO structures have evolved this year with larger deal sizes and delayed draw triple-A tranches to prevent cash drag.

On the documentation side, however, there have have also been some weakening of CLO structural protections.

The par value test is mostly calculated based on the double-B tranche rather than the single-B tranche, for example. There have also been some tweaks in the interest waterfall where the amount of interest being used to cure coverage tests first takes into consideration principal payments after the reinvestment period.

Less obvious leakage provisions include the use of principal to fund the reclassification of an LMO (loss mitigation obligation) to a CDO (collateralised debt obligation) without any sort of conditions, which could lead to par erosions, said one panellist

There have also been proposals for multiple payment frequency switches, and instances of optional redemption at less than par with just ordinary resolution.

Meanwhile. credit enhancement has also been going down but there has been a bit of pushback from investors. Investors have also pushed back on snooze drags, which were prevalent last year

9. M&A always on the cards, but process is difficult

Buying a CLO manager is a difficult process, with a number of bidders involved, one panellist said, adding risk retention makes it especially complex.

If the manager is holding the risk retention, it's difficult to move the management contract over to the new platform (with people potentially buying the manager entity and incorporating that into the new business). These management entities may also have other lines of business, other management advisory contracts or hidden liabilities involved in their platform

There are also cultural considerations with managers having their own styles and different investor stips. And while CLOs don’t usually have change of control clauses in them, warehouses and retention financing often do.