European structured credit is going through interesting times. Though the European Central Bank (ECB) has taken steps to strengthen and encourage growth in the market, a wide range of factors are influencing it and creating uncertainty.
Political division over the ECB’s quantitative easing measures, the asset quality review of the banking sector, new regulatory requirements including Solvency II and risk retention – all are important considerations when looking at structured credit in Europe. Although caution is required, CLOs offer value to those with the expertise to navigate these challenges.
Europe is awash with liquidity, as evidenced by declining usage of the ECB’s asset-backed securities (ABS) and covered bond repo facility and the lukewarm reception given to its attempt to encourage bank lending through the targeted long-term refinancing operation (TLTRO). In September, the central bank announced that a mere €82bn of the €400bn in cheap loans offered to banks had been taken up. A huge supply of new CLO issuances have gone at tighter spreads, influenced partly by ECB president Mario Draghi’s September announcement that the bank planned to commence ABS and covered bond purchase programmes in Q4 2014.
These events are occurring against the backdrop of a struggling European economy in which interest rates stand at record lows. In the current low-growth environment, investors are in search of yield, resulting in a sellers’ market in pricing and terms. There are already signs of overheating in the leveraged loan market, with higher debt to EBITDA leverage multiples, tighter loan spreads and a pickup in products such as covenant-lite. In Europe, low interest rates are without doubt helping to camouflage problems at corporates: default rates are at near-historic lows despite the sluggish economy. When interest rates do increase, weaknesses will be exposed, although rate hikes in Europe are a year or two away and likely to be gradual, and the effect of potential US rate hikes on the global economy remains to be seen.
To survive in a challenging environment such as this, which encourages loose lending in a weak economy, it is vital when investing in ABS and CLOs to be very selective in terms of deals and structure, as well as portfolio allocation. Particularly in the higher-yielding, riskier parts of these securitisation transactions, it is important to consider various stress scenarios for key sensitivities, analyse assets carefully and continually monitor investments at a granular level to achieve sustainable risk-adjusted returns. It is also essential to focus on deal documentation, and managers with good track records and credit/trading skills who understand credit cycles and different market environments and can react quickly to any unforeseen problems.
QUANTITATIVE EASING (QE)
Over this market, of course, lurks the spectre of QE. So far, investors have benefited from tighter ABS spreads across the board since ECB president Mario Draghi’s September announcement, including on non-eligible securitisations such as CLOs.
Draghi’s announcement in early October lacked key details on size, pricing mechanism and the mezzanine tranche purchase, and was followed by apparent political disagreement between central bankers, who have dampened the market expectation of the ECB’s ‘whatever it takes’ stance to revive the securitisation market. At present, the ECB operation appears set to be a much tamer beast than the extensive toxic asset programme implemented by the US Federal Reserve, which contributed to the growth of alternative lenders there.
Further, it is clear that European banks’ main issue is not funding but capital preservation. The recent surge in contingent capital bond issuance – standing at €51bn to date this year, according to Bloomberg – is a clear sign that European banks are taking advantage of the yield-starved market to raise capital. It is to be hoped that capital-raising/saving activities such as these will boost banks’ capital and ultimately revive SME lending in the long-term, which is the ECB’s goal in order to kick-start the eurozone economies.
ASSET QUALITY REVIEW (AQR)
The timing of a full-blown QE programme with mezzanine tranche purchases may be unknown, but one development of interest in the near term is the banks’ AQR. At the time of writing, the results of AQR and stress tests were unknown, but this exercise may well lead to more capital raising activity or sales of illiquid assets by banks.
Concurrent to the ECB planning unprecedented QE for banks, new regulations are proposed that will introduce higher capital charges for securitisations, as well as additional burdens in reporting and stress testing. As they stand, the proposed Basel III and Solvency II regulations will make holding ABS significantly more expensive from a capital/liquidity coverage standpoint. This is despite the strong historical performance of European ABS relative to both its US counterpart and European structured finance as a whole. Under Basel III’s proposed external ratings-based approach, the capital charge on a five-year AAA-rated ABS bond is set to rise from seven per cent to a massive 25 per cent. A similarly steep increase is proposed for the Solvency Capital Requirement under the Solvency II rules for European insurers, which are expected to be effective in January 2016.
Compounding these conflicting measures is continuing uncertainty about the translation of existing regulations, for example the retention rules under article 405 of the Capital Requirements Regulation (CRR). Although the market has found various solutions involving usually thinly capitalised CLO managers becoming sponsors retaining the stipulated five per cent or the creation of an originator entity, all of these mean more time is needed to structure deals.
The retention rules were introduced to prevent a repeat of the 2008 mortgage crisis but actual value added to investors in the CLO market has been limited. This is especially the case in broadly syndicated leveraged loan CLOs, where managers’ interests are naturally aligned with those of investors because their subordinated and incentive fees are at the bottom of the waterfall. As senior fees are typically only 15 basis points, CLO managers need to earn the junior-ranking subordinated and incentive fees in order to support their operation.
Further, as many of the underlying loans are large, widely syndicated issuances, it is unlikely that one participant can influence the loan documentation and pricing. Whereas retention in broadly syndicated CLOs is largely a regulatory burden, the situation is quite different in private CLOs.
Here, retention is critical from a risk standpoint: investors will want the manager to have ‘skin in the game’ because they are negotiating/originating the loan and, to that end, they may require the manager to hold even more than five per cent.
Caution is needed in this challenging, complex, low-growth environment but clear opportunities remain for securitisation investors.
We see relative value, for example, in the AAA CLO, which has performed well throughout the crisis and is structurally well-protected. Although there has been significant spread compression, spreads are still higher relative to other securitisation asset classes. At the more senior parts of the capital structure, where there is a 130-140 per cent over-collateralisation for these transactions, defaults on the underlying portfolios would need to be very significant to create substantial losses.
Looking at returns still to be had, at around 130 basis points over the floating rate on the most senior parts, AAA European CLOs remain very attractive from a relative value perspective and can provide value for the well-informed investor.
SCIO is an asset manager specialising in European structured credit. SCIO’s conservative approach to achieving sustainable value for its investors, its analytical tools and its senior executives’ long, cyclical experience within the European structured credit market make it ideally placed to negotiate the current conflicting market and regulatory environment for CLOs.
Eriko is a director in the risk management team. Prior to SCIO, Eriko worked for three years at Deutsche Bank’s London-based Credit Risk Management group, covering securitisation and distressed portfolio transactions. Before joining Deutsche Bank, Eriko spent seven years at Ambac Assurance UK, responsible for negotiating and executing European cash and synthetic securitisation transactions. Eriko started her career at Bank of Tokyo-Mitsubishi, London, in the derivatives marketing team.