Issues with issuance

The European Collateralised Loan Obligation market has made a sluggish start to 2017. While volatile loan spreads curtailed activity 12 months ago, a lack of supply has slowed managers this time around. 

Strong valuations in the equity markets and excess cash on balance sheets should, in theory, lead to merger and acquisition activity. This would, in turn, generate the loans needed to fund such transactions. However, the amount of loan liabilities available for purchase in Europe isn’t particularly big, executives familiar with the space told PDI.

“There’s been just a clutch of deals in Europe,” says Jonathan Bowers, partner at CVC Capital Partners. 

An executive with knowledge of the European CLO market adds: “My view is that the issuance [of CLOs] in Q1 has been slower due to a lack of collateral.” He also notes that 2016 was relatively strong for CLO issuance in Europe, with more than €16 billion raised across 40 new issuances. 

This year’s slow start follows a flurry of activity at the end of 2016. In December, Och-Ziff announced it had raised €413 million for a Europe-focused CLO, while US-based Carlyle Group closed its fourth CLO of the year.
CVC priced its latest CLO in February at €415.6 million. At the time, Bowers noted the slow market, but said there were a few CLOs in the pipeline soon to be priced. 

Despite struggling to find new issuances, CLO managers haven’t waivered in their desire to bring product to market. “If you talk to CLO managers right now they are starving for paper,” Renaud Champion, head of credit strategies at La Française Global Investment Solutions, insists.

Investment attractiveness  

Throughout 2016 the lower tranches of CLO products represented greater value than investment-grade and high-yield bonds, Champion says. That value, however, has shrunk. CLOs are now less of an attractive option than they were 12 months ago. 

In Champion’s firm’s fund products, the allocation to CLOs has been curtailed. “We moved from 35 percent of our NAV in CLO products to 5 percent,” he says. “We got rid of pretty much everything.” 

In particular, Champion notes the leveraged loan market, a central source of loans for CLOs, is “frothy” at the moment and perhaps overvalued. “The only way that leveraged loans can go is down [in price],” he says. 

There’s also a risk of CLO managers showing a lack of discipline when it comes to buying loans for their portfolios. With a lack of issuance and a requirement to be fully invested, Champion says it’s possible managers are forced to buy loans even if they don’t represent good value. 

Managers may be forgiven, however, for being bullish about CLOs based on the recent performance of the asset class. According to a report from Citigroup, equity tranches in European CLOs have achieved performance comparable with private equity investments in recent times and exceeded their US-domiciled counterparts. 

Equity in European CLOs with vintages between 2013 and 2015 has returned an average of 17.7 percent since inception, the report notes. That compares well with US counterparts of similar vintages, which have returned 12.2 percent on their equity. 

Those returns are, however, likely to come down in 2017 due to tightening spreads, one manager told PDI. Compared with investment-grade and high-yield fixed income, however, the returns are still noteworthy. “If that moved down to 14 percent that wouldn’t be a bad return,” the same manager notes.

The yield offered by CLOs, in light of low interest rates, is something to which investors should gravitate. “From a yield perspective, generically, the CLO space is very attractive,” says Bowers.

Concerns over interest rate movements could also increase investor demand for CLOs, he adds. Though he says his firm isn’t anticipating a rise in European interest rates in the near future, certain characteristics of CLOs would be a boon to investors in such an environment. 

“They are floating-rate instruments,” Bowers notes, while adding there has been something of a popularity surge in the US where interest-rate rises have already been implemented. “There is more of a dynamic shift in the US from fixed rate to floating rate. I don’t think we’re quite there in Europe.” 

Bowers says he doesn’t expect to see rate rises in Europe until 2019.

The performance of CLOs should also benefit from a low default rate environment in Europe. “From a credit standpoint, Europe is in better shape than it has been in years,” says Bowers. “We have a very short watchlist at the moment,” he adds, noting such a list consists of borrowers CVC would be worried about. 

A low default rate should ease concerns for investors in the equity tranche of CLOs. While Champion’s outlook for CLOs isn’t necessarily positive, he does say he would rather be in the equity tranches than hold the debt of the vehicles. 

With the CLO market resurrecting itself post-crisis in 2013, the last six months have seen an increase in refinancings. An environment with tightening loan spreads has seen equity holders in CLOs look to boost their returns through this process. The spate of activity also includes a number of notes issued to debtholders in CLOs reaching the end of two-year non-call periods. CLOs priced in 2014 and 2015 are now reaching the end of such periods and are participating in refinancing activities.

“You’re seeing quite a bit of refinancing activity,” says Bowers. Part of this includes resets where the CLO’s reinvestment period is reset and extended, he adds.

CLOs refinancing debt tranches should lead to higher returns for equity holders, says Bowers. With debtholders being paid lower interest rates due to refinancing, the prospect of more capital being available for equity investors increases.