The secondary market for European CLOs has been thriving all year, as amortisations and improving economic sentiment have whetted investor demand well beyond what the primary market can supply.
Despite the keen bid, spreads have stayed attractive to investors for much of this time. Maturing secondary paper was offering quicker returns at prices that were still fairly generous.
But mezzanine investors should think twice about continuing to buy in secondary, for two reasons.
The first is obvious: spreads have tightened much faster than in the primary and now look unattractive.
The second negative is less patent. Though secondary paper often has a much shorter remaining life than primary, vintage notes are considered more exposed to credit deterioration if there is an economic downturn. They are not paying the premium they should for the extra risk.
Half-baked spread
Comparing historical spreads in both markets is an indictment of the secondary. From August 2023 to August 2024, double-B notes tightened an average of 190bp in the secondary market, but only 71bp in primary.
Though August is the last full month we have data for, it is a weird and fairly illiquid time, when European investors hit their northern cabins and Baltic strands for a well-deserved holiday.
Perhaps it would be fairer to compare movements from last July to this. That difference is less stark but just as obvious — double-B spreads tightened by 123bp in primary and 185bp in secondary.
It is possible some investors simply could not get enough primary paper in which to park all their cash, forcing them to chase assets in secondary.
In this busy month of September, however, new issuance has approached the heights of the Covid era, with at least 15 deals out in the market and many more in the works.
While savvy investors sold secondary positions in early September to buy into the deal flow — culminating in €500m of bids wanted in competition (BWICs), according to BofA Global Research — secondary spreads did not widen at all with the sudden wave of supply. In fact, they tightened by 5bp across the capital structure.
The average double-B spreads in August were 660bp over three month Euribor in the primary market and 640bp in secondary.
For triple-As, spreads are 130bp and 105bp, a very wide gap. The split for mezz is narrower, but less justified.
That price gulf should be enough to convince most mezz investors to cycle into the primary — many already have.
But the risk differences between the two markets are another issue altogether, and call into question why secondary paper should price deep inside primary at all.
Blue in the Black Forest
It goes without saying that economic performance is a particularly pressing concern for subordinated investors and that the bottom of the CLO cap stack is very much exposed to default risk.
While recession fears seem to have eased in the US, it is very hard to say the same for the European Union. The German economy is contracting for its third straight month, with business confidence declining and the car industry struggling to stay afloat.
Similar fears cut across the EU, as the French economy is shrinking after a brief boost around the Olympics and eurozone business activity has shown its worst performance since February.
Since CLOs are based on high risk business loans, this is not the most encouraging news for investors.
Fortunately, the asset class has proved remarkably resilient, most obviously because managers can weed out and sell undesirable loans.
Another upside, of course, is that a recessionary outlook will drive down interest rates, helping managers acquire better loans and boot out the old ones.
The problem is that a lot of secondary deals are out of their reinvestment periods, or almost out. Once that happens, there is little a manager can do to combat increased default risk. Nothing in the secondary market suggests investors are factoring in this additional risk.
To a triple-A investor this probably will not matter. They want notes that are going to be paid off quickly and are little exposed to default risk.
The situation could not be more different for mezz investors. Now that new issue volume is back, it is very difficult to justify putting money into the secondary market.
Something has to change. Secondary spreads should start approaching the primary market, especially for deals whose reinvestment period is over.
In the meantime, investors could healthily cycle into the sea of new issues. You not only secure better pricing but are buying a more resilient product as the EU economy takes a turn for the worse.