Technically charged CLO market looks to push on but tail risks linger

With issuance records tumbling and the asset class performing strongly, it’s hard to argue that 2024 was anything but a good year for European CLOs. And GlobalCapital’s survey of market participants in November suggests that things can get better still.

Yet in the background, trade tensions linger, higher interest rates may still catch up with borrowers and there is a disconnect between technicals and fundamentals. Some investors and managers say they are preparing for greater tail risk.

“I personally expect next year to be tougher [for some portfolio managers],” says Robert Reynolds, head of CLOs at Pemberton. “I expect technicals to continue to dominate for the first six months and then you will see certain sectors that may become more challenged.”

The overall view among market participants remains more bullish than bearish. In GlobalCapital’s market outlook survey, 59% of participants said they expected higher issuance in 2025. Another 32% predicted stable volumes and only 9% said they expected a decline.

Most were also constructive on pricing, with 79% expecting spreads to tighten or stay close to current levels.

By November 10, European CLO managers had printed just under €43bn of new issues in 2024, according to Kopentech. Volumes had surpassed the 2021 record of €38.3bn, as well as all bank forecasts from the start of the year.

Investors absorbed the intense activity well. Primary market spreads on triple-A rated paper tightened rapidly from the high 170s at the end of 2023 and stabilised to around 128bp-130bp by October.

This was partly due to growth in the investor base. Bankers said new demand came especially from regional European banks entering the market, as well as from US investors looking across the Atlantic.

“CLOs have continually become more of a mainstream credit product that investors need in their portfolio, rather than having to justify why they are investing in CLOs [as they did] in the early 2.0 days,” says Hugh Upcott Gill, co-head of EMEA CLO primary at Jefferies. “With the growth of the investor base, the outlook for investor demand into early 2025 is reasonably strong.”

A key driver of both demand and supply has been a technical. Typically, CLOs get reset at the end of their non-call periods. But after spreads widened dramatically in 2022, resets became uneconomical for most vintages for around two years, leading to unusually large volumes of amortisations and liquidations of seasoned deals.

This chipped away at managers’ assets under management and flushed cash back into investor pockets, especially at the top of the capital stack.

“It seemed like a record year of issuance, but on a net basis it wasn’t particularly high,” says Upcott Gill. “This level of issuance is well supported if you have the amortisations and liquidations of the existing universe.”

Although managers had printed €22bn of triple-A rated CLOs in Europe by the end of October, net supply was only €7bn, according to Bank of America. Across the capital structure, net supply in Europe was €16bn, less than half of gross issuance.

Managers were also working through a backlog of older warehouses.

These dynamics are expected to continue to drive new issuance next year, although to a lesser extent as the situation gradually normalises. At the same time, resets are likely to pick up.

Refinancing and reset activity in 2024 stood at €25bn on November 12, less than half of the full year 2021 figure of €59.4bn. And despite the hefty tightening this year, spreads are still historically wide. Before central banks began raising interest rates in 2022, some managers were pricing triple-As with double-digit spreads.

As a result, most reset activity this year came from deals that had been priced in the last two years at even wider levels.

“We should see more resets in Europe,” says David Nochimowski, head of global CLO and ABS strategy at BNP Paribas. “The US has been leading with big volumes, but Europe is now starting to catch up.”

The scope of resets has been broadening since the summer as tightening across the stack allowed some managers to reduce their weighted average cost of capital — even if it meant a widening of triple-As.

“It’s important to look at the less obvious call candidates: the more seasoned deals from 2018 or 2021,” says Nochimowski. “They’re callable all the time. We think that a large part of the reset activity next year both in the US and Europe is going to come from those deals.”

A recovery in leveraged loan issuance should also support CLO creation next year. October was the busiest month in underwriting activity in the year to date, bringing gross leveraged loan volumes to €64bn, according to BofA.

Most of the activity consisted of refinancing and ‘amend and extend’ deals, although leveraged buyouts are making a slow return with €23bn of activity in the year to November 12 — almost twice 2023’s volumes. This could pick up with more rate cuts.

Primary market activity in Europe could also receive an injection of life from the emergence of middle market CLOs.

The asset class, normally used to fund direct lending, is well established in the US but virtually non-existent in Europe. It could begin to develop in earnest next year, with Barings set to be the first manager to test demand for the product.

“Barings’ deal may well be a catalyst for momentum to increase more quickly once issuers have more certainty about takeout,” says Upcott Gill. “We have seen some hybrid middle market and BSL [broadly syndicated loan] deals historically, but this may signal the start of a more established European middle market and private credit CLO market.”

Several direct lenders told GlobalCapital that they are watching the deal closely.

“As we head into Q1, we expect to see a lot more interest in doing middle market CLOs,” says Sandeep Chana, EMEA CLO director at S&P. “It’s likely to start off plain vanilla with straightforward assets and limited PIK features. But slowly, we think you will see more add-ons coming through so you can diversify the portfolio and include more names where it makes sense.”

Optimism is tempered, however, by creeping macroeconomic risk, which CLO managers and investors view as their number one concern. Although credit markets initially reacted very positively to Donald Trump’s victory in the US election, his potential introduction of import tariffs could slow down already muted eurozone growth.

For the past year, the market has shrugged off all news that shook the political landscape, from the tensions in the Middle East to the snap election in France. It behaved in line with wider financial markets that breezed through any geopolitical volatility to such an extent that the IMF warned about the disconnect between global uncertainty and market reactions.

In the CLO market, some feel this unease.

“There is a dislocation between financial markets on one hand and the real economy on the other hand, especially in Europe,” says David Altenhofen, head of investments at Accunia Credit Management. “We could see some volatility spikes in financial markets in the coming 12 to 18 months, because the tightening of spreads this year seems more technical than fundamental-driven.

“Investors should be cautious at this point because it feels like there’s some tail risk out there, [for example] a new trade war between US and Europe affecting growth.”

Some CLO managers say that they are preparing for tail risk that could arise from isolationism.

“On the whole, we’ve chosen companies that have lower leverage and larger capital structures, so they are more liquid,” says Reynolds at Pemberton. “This means a more defensive book and I don’t need to buy into the technical.”

For now, indicators of market distress are fairly calm. Only around 2.5% of the European Leveraged Loan Index is trading below 80, while another 2.7% is trading between 80 and 90. At the end of October, Fitch’s loan market concern list contained just over 3% of the market.

In August, S&P reported a default rate for speculative grade debt (including high yield bonds and leveraged loans) of 4.7% for the 12 months to June 2024. The rating agency predicted that the rate would level out at 4.25% by the end of June 2025.

“I’m quite constructive about our market,” says Daire Wheeler, head of European liquid credit at Alcentra. “Fundamentals are in a decent place. While not seeing high growth, they’re not negative and none of them point to a spike in defaults.”

Potential trade wars between China, the US and Europe would likely hit the equity and high yield markets harder than leveraged loans, according to Wheeler. Tariffs would predominantly affect big industrial companies, and many in the market single out German car manufacturers, while the European loan market is mainly exposed to services, healthcare, and technology, media and telecoms.

Nerves in the market have led to an overselling of some credits associated with volatility risks, Wheeler says.

“I personally think there’s more upside than downside on some of the triple-C credits as they evolve,” he says.

CLOs are gearing up to prove their resilience once again.