The buoyant European CLO market is set for a busy second half of the year, even though the return of leveraged buyout activity appears no less elusive than six months ago.
Issuance so far this year has exceeded all expectations, with €19.1bn of new CLOs priced in 2024 as of May 16, according to KopenTech. Resets and refinancings accounted for a further €4.9bn of activity.
Several banks have increased their new issuance forecasts, with Deutsche Bank the most optimistic, having raised its full-year prediction to €37bn. If this materialises, it would make 2024 the second busiest ever — just below 2021, with €39bn.
“The summer will remain busy,” says Steve Baker, head of European CLO primary at JP Morgan. “There is this misconception that the market stops in August in Europe. Yes, some investors go on holidays for three weeks, but it’s not that common. Frankly, almost every investor will be open for business, so they will have someone there.”
Yet the intense activity is being driven by high demand for CLO liabilities, rather than by managers spotting opportunities in the loan market. Institutional investors, especially pension funds, are keen for investment-grade debt. With triple-A spreads in the mid-to-high 140s, CLOs look cheap compared to other asset classes.
Moreover, as floating-rate instruments, CLOs offer protection against volatility while markets are still uncertain where interest rates will go.
Running to stay in place
Some of the demand is driven by amortisations of deals that are outside their reinvestment period. Repayments of vintage CLOs put money back into investor pockets, especially at the top of the capital stack, and the cash then needs to be redeployed. Deal liquidations also encourage managers to issue fresh CLOs to maintain assets under management.
“In the US, there are so many deals being called or [that] were just paid down on the April payment date that investors were in a rush to put that money back to work,” says Baker. “We are seeing a similar dynamic in Europe, just not to the same extent.”
In the US, there are so many deals being called or [that] were just paid down on the April payment date that investors were in a rush to put that money back to work. We are seeing a similar dynamic in Europe, just not to the same extent
Another banker says that portfolio sizes are staying largely flat despite the strong demand for paper, while some investors describe a sensation of “running to stay in place” — although not all parts of the market are feeling a big impact of amortisations yet.
“I would say it’s two thirds fresh money and one third reinvestments,” says Doug Charleston, partner and portfolio manager at TwentyFour Asset Management. “Amortisations are underway, but not in full flight yet. They could build towards the end of the year.”
While most of this new money is coming in at the top of the capital stack, appetite for the riskiest slice is also returning. CLO equity was nearly impossible to place with third-party investors from summer 2022 to the end of 2023, but the situation has improved with the rapid tightening of spreads at the start of this year.
Mezzanine tranches have tightened even faster than senior notes and are trading closer to their 2021 levels. The reduced cost of capital across the stack, especially the lower yields on single-B tranches, has made equity more attractive again.
Several managers have been able to sell at least a minority stake in their equity and some — like Sound Point and Brigade — even had majority investors. Although bankers say that it has so far been difficult to consistently place third-party majority equity, there are signs that demand for first-loss tranches will grow in the coming months.
“[We are] seeing early capital formation for third party equity starting to materialise,” says Charleston. “The pipeline there seems reasonable, although that will have a medium-term rather than a short-term impact.”
More tightening ahead
Market participants are increasingly optimistic that spreads could tighten further. Triple-As were stuck in a range of 147bp-150bp for most of March and April but edged towards 145bp in May thanks to sustained investor appetite.
“I could see spreads hitting 140bp in the not-too-distant future,” says Baker. “It does feel like we are still on a tightening trend.”
One CLO manager argues that there is no fundamental reason preventing CLOs from getting to 130bp in the medium-term or to 110bp by the end of the year, as there is still room for demand to grow further, for example if the exchange rate from Japanese yen to dollars and euros improves.
“I think that will compress and [appetite from] Japan will get bigger,” says the manager. “Japanese banks are getting taken out of a ton of paper in refinancings and resets, so they are running to replace all that.”
Some investors say that the market should be wider because of geopolitical risk or macroeconomic uncertainty, but most of them do not expect spreads to move out much. Triple-A spreads are still wide compared to other asset classes, making them attractive to a variety of buyers.
“We had a few years where issuance momentum built and caught people off guard into the summer and it has normally driven spreads wider by this point in late May,” says an investor. “I’m not sure we are seeing signs of that on triple-As […]. That part of the market is just too cheap.”
However, some CLO managers tell GlobalCapital that they do not see potential for much tightening either, as long as the technical factors of supply and demand remain the main driver.
“No single group of buyers — US banks, European banks, Japanese banks, insurance companies — is deploying capital in a manner that would artificially drive spreads tighter,” says Erik Miller, co-head of the CLO business at Canyon Partners. “It feels like a pretty healthy arms-length market. Improving economic data could move spreads tighter.”
European CLO AAA spreads for the past 12 months
Excluding static deals (that tend to price much tighter) and resets
All statistics are calculated based on the transaction pricing date
Source: KopenTech
Asset struggles
Loan supply is expected to remain the biggest challenge for issuers in the months to come. Although activity so far this year has exceeded expectations, with €29bn of issuance in the first quarter, much of this was driven by amend-and-extend deals or refinancings from direct lending into the broadly syndicated loan market. Leveraged buyout volumes have not yet rebounded to the extent that some hoped for at the end of last year.
“Higher-for-longer rates, geopolitical risk and the fact that there is a lot of election activity this year do not make a favourable backdrop for LBOs to pick up at pace,” says Martin Hallmark, senior vice president of the corporate finance group at Moody’s Ratings. “We are starting to hear of more transactions in the pipeline, but it looks like a very gradual process at this stage.”
Two loan bankers also say that they see — at most — a “slight” increase in M&A activity over the summer.
High volumes of CLO issuance have created big demand for assets and driven prices higher in the secondary market. Around 26% of the European Leveraged Loan Index was trading above par in early May, according to BofA Global Research.
To make the arbitrage work, managers need to source a substantial portion of their loans in the primary market with a new issue premium. This creates a highly supportive market for leveraged European credits, but it challenges the discipline of managers.
“The market is open and therefore, some companies that we might view as inferior credits do have access to the market right now,” says Miller. “But within the mix are a number of good loan assets that we can buy.”
Most managers emphasise their focus on credit risk, although some warn that investors should keep a close eye on what is in portfolios.
“Everyone says that they are selective, but I think they’re not too picky,” says one CLO manager. “They can’t be.”
Covenant caution
An undersupplied loan market not only gives lower-rated borrowers a potential entry point into CLO portfolios. It can also lead to weaker lender protection in loan documentation — an issue brought to the forefront of debate by the recent struggles of certain highly levered obligors, including telco Altice, that are widely held in CLO portfolios.
CLO managers told GlobalCapital that they have been pushing back against certain clauses that would allow companies to sell assets without using the proceeds to pay off debt. One manager said they insisted on a super majority threshold for changes of jurisdiction to prevent the company from moving under US law in case of a restructuring.
“There might be some willingness to fix certain clauses that prove problematic, but I don’t think we will see a massive tightening of docs,” says Arthur van Schie, head of leveraged loan capital markets EMEA at ING. “With limited deals coming to market and a lot of demand for them, sponsors remain keen to maintain their precedent documentation.”
However, investors say that they are confident in the resilience of CLOs, even in a difficult market. Investment-grade tranches are largely shielded from credit risk — no triple-A tranche has ever defaulted in the history of the asset class, according to S&P.
Mezzanine buyers point out that the problems of companies like Altice, Intrum and Ardagh are idiosyncratic situations rather than signs of heightened risk in any sectors of the economy.
“We could see more volatility going forward,” says David Altenhofen, head of investments at Accunia. “We will probably see higher default rates and lower recoveries, especially in the loan space, but unless we see some kind of systematic shock, the CLO market should keep functioning fine.”
He adds that CLOs also proved themselves during the liability-driven investments crisis in 2022, when the UK mini budget of then-prime minister Liz Truss caused pension schemes to scramble for cash.
According to Altenhofen, “when push came to shove, institutions sold CLOs, not ABS or CMBs or whatever they had on their books, because CLOs were the most liquid assets within the alternative bucket.”
Charleston at TwentyFour says he does not see any “glaring problems” awaiting the CLO market in the second half of the year, although he is “slightly concerned” about increasing leverage. Par subordination is varied between CLOs at the moment, and most in the market agree that the backdrop is weakening, even if they have different views on speed and severity.
Considering the strong spread performance this year, a correction seems likely, particularly in mezzanine bonds, he says, adding: “If one of the rating agencies comes out and changes its general assumptions, for example, there is a potential for a wave of downgrades.”