As the gloomy economic forecasts pile up, market participants in both European and US CLOs have tended to fall back on the same argument when explaining their confidence in their product despite the gathering clouds.
“We survived Covid,” they say, before going into further detail that usually entails repeated use of the word ’resilience’.
Yet this claim of resilience feels misplaced, since during Covid governments around the world provided much of it in the form of unprecedented fiscal and monetary support to their economies.
Between the Trump and Biden administrations, the US government approved more than $4.5tr of extra spending. The EU pledged more than €2tr of support in its largest ever stimulus package.
The UK had a furlough scheme to prevent unemployment from rocketing and policies such as the Eat Out to Help Out scheme to get the struggling hospitality sector going again.
To claim CLOs were a resilient asset class, when there was so much economic support propping up the underlying collateral, is a bit like any claim one might once have made that Lance Armstrong was the greatest cyclist of his generation.
Now, the global economy faces a transition away from 40 years of low inflation and low rates to higher rates, higher inflation and greater uncertainty. Many individuals and businesses will struggle to adapt, but the tonic this time looks certain to be different from 2020. Governments are unlikely to throw trillions of dollars, euros or pounds at struggling businesses and workers.
As a result, the default rate in leveraged loans is expected to rise above the 2% threshold that CLO managers tend to find comfortable. Fitch Ratings predicts it will hit 3% in Europe next year, and if it were to rise above 4% then the viability of further CLO issuance will be called into question.
Getting equity investors on board to form news deals is already proving tough. The CLO market may be about to undertake a far truer test of its resilience.