How much supply?

Sellside guesstimates for supply in the year to come seem pretty range-bound, from a low end of €30bn-€35bn at Barclays to a high of €37bn at Bank of America, with JP Morgan and Deutsche Bank slotting in between at €35bn and €36bn respectively 

Different banks have different ways of getting to the number, but a popular approach seems to be taking 2021’s record-breaking volumes and subtracting a little — perhaps on the basis that next year can’t be this good again. Certainly the first half of the year featured some Covid catch-up, as managers who’d sat tight and rode out the worst of the pandemic widening finally came back to market.

But the bull case is…..what’s to stop the market? Omicron caused nothing but a gentle hiccup in the secondary market, with primary market prints rolling on, and any widening nowhere near enough to knock the overall economics of doing deals.

To put it another way — €35bn of new issue supply is only 1.45x €400m deals per manager in Europe. The likes of Redding Ridge and Palmer Square, Europe’s most prolific issuers, are running at five deals a year, there are no real obstacles to any established manager returning, and it will take considerable restraint and patience to resist the urge to print at least a couple. 

Some managers don’t have the equity capacity to do more than one, and indeed market this as a strength — low deal counts mean managers can be more nimble and selective than firms trying to ramp three deals at once. These may be willing to hold themselves to the 8 month deal cycle implied by the 1.45x average. But that could well be closer to the minimum issuance per manager, not the average — suggesting considerable upside from €35bn if conditions stay strong.

But will they? Omicron didn’t seem to disturb the execution of CLOs already in the pipeline much, if at all — new primary spreads since the news of the variant hit remained mostly in line with late November at the senior level, with slight softness down the stack, but WACCs for new issue remain basically attractive compared to loan spreads.

January should come, as it usually does, with fresh capital to invest, refreshed risk appetite, and deeper liquidity — which should set the tone for a strong year ahead.

Resets and refinancings

Resets and refinancings are much harder to call, since they’re highly sensitive to credit spreads — and, given the small number of large buyers at the top of the CLO capital structure, the spread is highly sensitive to market technicals.

To put it another way, it only takes a couple of big accounts to step back for senior spreads to widen, wrecking any carefully made reset/refi predictions. Bank of America’s team said: “The sensitivity of call action to WACC (weighted average cost of capital) is high with the call count moving by a factor of two for a WACC move by 10 bps in each direction”, but predicted continued strong reset/refi volume at €35bn.

Deutsche meanwhile expects €40bn, and Barclays €10bn-€15bn, reflecting the difficulty of accurate analysis of the forward spread outlook for CLO liabilities.

The picture gets further complicated by the non-economic factors feeding into decisions to refi or reset a deal, and the extent to which existing holders choose to roll their positions. 

In 2021, roll rates were often relatively low, with some large investors, notably the big Japanese banks, choosing to step back and allow deals to be refinanced away, and others taking the opportunity to refine their existing manager selection — dropping poor pandemic performers and picking up others.

This meant that many of this year’s resets were in effect, new money supply — they could not count on existing holders to stay invested, so were competing alongside true new issue against the same CLO investor universe. Depending on the supply-demand dynamics elsewhere in the CLO machine, investors may want to keep hold of existing bonds and roll rates could start to rise again.

2021’s reset picture was also complicated by documentation factors and substantial revisions to rating agency rules — Moody’s last December, Fitch this summer — which ease WARF constraints for CLOs and give more leverage headroom for structures. Moody’s market share in European CLOs fell off a cliff during the pandemic, to the particular benefit of S&P and challenger Kroll. 

But with increased leniency in rating criteria this year, some of the resets of 2020 deals moved back to Moody’s and Fitch for better treatment. Resets also allow deals to be fully redocumented, giving managers greater flexibility to deal with restructurings and contribute new money, or allowing them to add ESG language to older deals.

Restructuring / workout obligation language became a regular feature of deal docs soon after the pandemic hit, with fears of a flood of Covid-driven workouts motivating the move — and a couple of high profile US restructurings, notably Acosta, underlining how constrained CLO managers could lose out to more nimble credit opps funds when it came to recovering value.

Unlike new issues, though, reset and refi activity is necessarily limited by outstanding issuance — and 2021 already made a huge dent in the potential candidates, with 2019 two year non-call deals and 2020 Covid-era one year non-calls looming large in the 2021 deal stats.

One oft-overlooked driver for reset and refi activity is the ability to flush trading gains through to equity, in a more flexible fashion than permitted during the normal life of a CLO. Many deals limit the calculation of trading gains, looking to the higher of par and purchase price. So buying a loan at 98 and selling for 101 would only produce one point of trading gains, rather than three — which limits the amount which can be flushed out from the trading gains account. Loan managers, mainly active in callable instruments, tend not to make most of their gains from buying above par and hoping for further appreciation. 

Nonetheless, the economic gain of three still sits in the structure — and resets and refinancings can be used to push this out to equity during the life of the deal. Deals from early 2021 will become callable in H2 2022, and some are likely sitting on substantial gains they’ll be anxious to distribute.

The exact split between resets and refis is hard to determine, and highly spread dependent. Sub-investment grade bond spreads have largely gone sideways, with little advantage to be gained from refinancing 2019 or late 2020 deals at current levels. Indeed, recent primary discount margins in the 940 bps - 970 bps range are approaching levels which would discourage managers from placing these tranches at all. 

Managers attribute demand volatility on the lower stack of the deals to fund fluctuations on the investors base. “It is not linear driven, if they get a ton of money, they tend to buy a lot and then the supply picture on the mezz side offers more paper. They can be opportunistic and rush to a lot of deals, but next year that can flip really easily again,” said a portfolio manager. 

The most popular refinancing option through 2021 was the IG-only refi, as these bonds were the only ones convincingly tighter than at original issue. A meaningful tightening in sub-IG spreads could tilt more managers, including those who have already refinanced, to reset as well.

Like much in the CLO market, though, market technicals could end up proving just as important as the economic backdrop. The pool of senior tranche investors is relatively narrow at the best of times, and shrinks to a mere handful (one source said just three) at the short end — severely limiting the scope of managers to refinance (which means syndicating a short-dated bond) if these investors aren’t involved in their deals.

What about rates?

The Euribor floors in European CLO tranches and persistent negative Euribor rates mean CLO debt, while nominally a floating rate product, has been acting as a fixed rate investment for years — largely to the market’s benefit, as the relative value of the Euribor floor+headline spread has come out exceptionally attractive compared to other high grade fixed income products.

This means that the Euribor curve should have a meaningful influence on the valuation of CLO tranches. If the Euribor forward curve steepens, the value of the floor goes down — though as CLOs will once again “float” if Euribor passes 0, they should still perform well compared to true fixed rate bonds in a curve-steepening scenario.

The whole question of rates rises is difficult, though, with policymakers caught between rising inflation and a further round of lockdowns and distress thanks to Omicron. We’ll let the macro guys walk through that stuff — but suffice to say, some steepening could be on the table for 2022.

Steeper curves could also mean more of a term structure emerging in CLO pricing — which, in turn, plays into the question of whether to refi, leaving a deal short-dated, or reset, and extend its life.

Current loan margins are hovering around 400bps for B2 credits allowing for smooth arbitrage. CLO managers expect that PE dry powder should fuel a strong pipeline of loans which should keep it that way in 2022. In the first quarter of 2022, the loan market tightened during a post pandemic repricing wave in a swift normalisation move underpinned by the vaccine rollout. The start of 2022 should be different with less opportunistic deals left to reprice while the new variant keeps margins elevated. If tourist money stays away from leveraged finance and investors remain disciplined it should keep CLO assets supply stable to support new issues. There are around 70-80 warehouses open at the moment, according to two CLO managers.

Terms

BofA’s CLO piece has an excellent longer term look at average deal terms through the CLO 2.0 era (since market reopening in 2013).

The simple takeaway is: deals have got longer and more levered since the market returned, with a brief Covid hiatus breaking up the broader trend. 

Deals in 2021 converged on a 1.5 year non-call 4.5 year reinvestment period structure, as Covid-era deals forced a rethink of the previous 2 NC 4 year reinvestment standard. Deals priced in 2020 mostly went short, with 1 year non-calls in the (fulfilled) expectation of refinancing more cheaply as soon as possible.

As the 1.5 / 4.5 structures works its way into resets as well as most new issues, CLO equity in Europe will have more optionality available than ever before — that is, longer periods of active management when their deals are callable, and shorter waits to potentially refinance than ever before.

This also goes hand in hand with more leverage, and leverage on better terms. Not only have deals got more levered in absolute terms — an average debt to equity of 10.7x in 2021, compared to 9.7 in 2019 and 6.7 when the market reopened in 2013 — but more of this debt is cheap senior. Average par subordination for triple A touched 38.3% in the second quarter, in line with the average for 2019, though well below the 40%+ which was normal before 2018.

Rating agencies have recently loosened terms, theoretically allowing deals to be structured with yet more aggressive par sub levels — Partners Group managed a 37% deal in Q4, though this didn’t necessarily help the deal’s overall cost of debt compared to a 38% or higher issue.

Fourth quarter deal size in 2021, at €435m on average, is also a 2.0-era high, though the blended €416m annual figure is broadly in line with most of the averages since 2014.

Some of the structural changes reflect real underlying changes in European leveraged credit. Structures can be more aggressive in part because the universe of European leveraged loans is much larger and more diverse than it was in 2013 — more and more like the US market each year. 

It’s true that the large cap issuers like the Altice and Liberty Global complexes, EG Group, Stada, and Ineos companies tend to be present in almost every deal — Altice France tops the table, in over 90% of European CLO issues — but the broadening of the loan market has helped managers to differentiate themselves further. 

Buying new issue as it comes to market is still a solid strategy — the OID provides an instant way to build par — but more and more large liquid capital structures exist in European leveraged finance and can be sourced in adequate size in secondary.

Deeper in the docs

Other 2021 deal terms are likely to stay put, or indeed increase, with most of them set to increase manager discretion. With the cut in “standard” deal fees to 40 bps all-in (15 bps senior and 25 bps sub) compared to the historic 50 bps (15/35), this gives managers more tools, but more pressure, to outperform their IRR hurdles.

Though it’s now market standard to include provisions on loss mitigation loans (flexibility for CLO managers to put new money into distressed situations), the mechanics of this provision still vary — particularly the extent to which a new money loan to a distressed company can be sold back into the CLO, and how it should be marked/bucketed.

Provisions on exchanging defaulted assets can also vary — managers can now exchange defaulted assets, providing this is better for the CLO in their judgement. That allows CLOs to participate in the very standard restructuring proposal of switching old debt into higher coupon, more senior, better protected debt in return for a principal haircut. 

But the new obligation does not necessarily have to meet the CLO’s ordinary reinvestment criteria, while it may also allow the CLO to effectively keep reinvesting after the reinvestment period ends — and increases the importance of manager discretion.

The complex mechanics around “Collateral Enhancement Obligations” — assets which don’t meet CLO tests, but remain in the structure carried at zero — have also evolved. These obligations are excluded from CLO tests such as the WARF and WAS, but contribute to the economic value of the portfolio, so their treatment can be a route to funnel economics down to equity.

There’s a vigorous debate to be had over the real implications of some of these moves. More flexibility for managers can in general be seen as equity-friendly, since manager and equity interests are usually very closely aligned, and many managers have captive equity in their deals.

But the flexibility to fully participate in restructurings, for example, should also be a debt-friendly feature. It’s vanishingly unlikely that even multiple failed restructurings would ever hurt the senior debt, but nonetheless, manager discretion ought to be helpful in supporting credit metrics right up the stack, enhancing par coverage and overcollateralization tests, for example. It may be a rare win-win for both equity and debt. 

It’s a live issue, though, with managers telling us that triple-A accounts in particular are focused on the details of Loss Mitigation treatment. Elsewhere, we’re hearing that debt investors are trying to tighten up the flexibility built into refis, following a spate of refi deals which extended WAL tests without the consent of the mezz. That could mean more resets down the road, as refi flexibility becomes increasingly constrained.

Two CLO managers mentioned getting pushback in increased documentation flexibility from their investors, as a trend to be viewed by some as more equity help than debt protection. However, the pushback has not been strong enough to be tied to a push for higher spreads to compensate if the docs had not been tightened. 

Loss mitigation treatment has been untested in practice, mainly because many managers are yet to experience defaults in their portfolio. Nevertheless, managers appreciate the new playing card not forcing them to sell out at 60s from a loan name they believe can recover. 

ESG

It wouldn’t be a 2021 piece without a mention of ESG — and it’s an area where the CLO market is expected to make further strides in the year ahead.

The first CLOs including ESG features started to hit the market in 2017, well before the HY and leveraged loan markets started to label debt or introduce sustainability-linked margins and coupons (though the investment grade market was a long way ahead by then). 

Fast forward to 2021 and there’s a wide variety of approaches operating in the market. A majority of European deals include some kind of ESG stipulations today, but these can vary dramatically in scope, application and severity.

The most basic approach is an exclusion list or “negative screen” — no investments in companies that are involved in some list of controversial activities, such as Arctic oil drilling, cluster bomb manufacturing, pornography and so on. 

In practice, the exclusion list often includes a revenue percentage figure. If an IT services company has a contract with, for example, gambling or pornography websites, that in itself wouldn’t necessarily put it on the exclusion lists, unless this made up a large proportion of its business.

More recently, managers have started introducing minimum ESG obligation scores (using proprietary models and scoring), such that deals have to report ESG scores across portfolios, and managers have to maintain average ESG score at a certain level. This feature is present in Fidelity’s 2021 market comeback, but Permira Debt Managers and NIBC Bank also include complex scoring mechanics in their deal docs.

Two European regulations have also started to shape CLO manager ESG strategies. The first is the concept of an “Article 8” fund — now very widely established in the broader investing universe, with more than €3trn of “Article 8” money under management. This stipulates that funds “promote” ESG characteristics. It’s a transitional definition, which makes it useful for asset classes where data on ESG is difficult to come by, and broadens the church of potentially ESG-aligned financial products.

CLOs are explicitly excluded from the regime — they use a regulatory safe harbour which allows them to avoid classification as investment funds, and therefore cannot be subject to investment fund regulations such as Article 8. But they can be voluntarily branded as “Article 8-aligned”, as Fidelity has done. 2022 ought to see more managers follow, though so far the wall of Article 8 money hasn’t done much to create price tiering, with Fidelity’s deal coming wider than several other issues coming to market at the same time.

Nevertheless, not to just exclude but also individually assess each company credentials is part of a forward-looking investment strategy for those who want to jump on early on the transition to carbon neutral economies, if they believe it will have a significant impact on their portfolios. Even if they are not getting greenium currently or are driven by future regulatory limits. 

Also they might believe that by excluding certain names, it creates negative implications in the market. “Excluding a lot of firms just creates assets with high premiums who will get bought by people who don't care about ESG investing and get high return,” said a CLO manager. 

The Sustainable Finance Disclosure Regulation is also affecting the CLO market — not surprisingly, mainly through the disclosures managers make about their portfolio. CLOs are already transparent to their investors about the portfolio, with monthly trustee reports detailing the underlying loans. But loan issuers often give little ESG information, and are highly sensitive about disclosure, especially if they have loan-only capital structures.

As with Article 8, CLOs are formally excluded — technical standards on securitisation disclosures under SFDR are still coming down the track — but that hasn’t stopped managers issuing “SFDR-ready” deals with enhanced environmental reporting commitments. This push is also coming from CLO investors who are becoming more “ESG-savy” and are starting their own SFDR funds. 

The SFDR implementation date has been pushed back into 2023, but it imposes large obligations on EU-regulated asset managers of all stripes – meaning prudent managers will want to give their investors a head start on meeting their new obligations.

New products

Here at 9fin we’re mainly about leveraged finance, and therefore mainly interested in large loan CLOs — the asset class known in the US as “BSL CLOs”, and in Europe as “CLOs”.

But the US market includes several products using similar technology which have yet to make it across the pond. Collateralised bond obligations had a chequered pre-2008 history, but are regular features in the US market, as are “enhanced CLOs”, targeting riskier collateral but with lower structural leverage.

Ellington Management began work on an enhanced CLO pre-Covid, and, though the product didn’t come off, the post-Covid landscape might offer more fertile ground for compiling and leveraging a portfolio of more stressed credits.

More promising is the CRE CLO, essentially porting over the BSL structure into the commercial real estate universe — allowing a CRE debt fund to find cost-effective leverage for a portfolio of middle market CRE loans.

One of these instruments has been issued so far in Europe, Starz Mortgage Capital, and others are in the works for a predictable list of CRE lenders — the likes of Brookfield, Blackstone, Starwood and Apollo have been whispered to us.

The Starz deal, and most of the rest of the first wave, will likely be static deals, allowing investors to focus on the collateral only, rather than taking a view on manager style and skills, as they do in the US. But the static deal is also a feature of the BSL market, as Palmer Square’s rapid run of deals has demonstrated — and if the CRE CLO market gets off the ground successfully, expect active deals to follow in the years ahead.