European CLOs: a mere flesh wound?
- The new issues of European collateralised loan obligations (CLOs) reached just under 4 billion from 12 transactions in October 2020
- New European CLO issues were down 26% year-on-year, with funding volumes falling from € 6 billion in 2019 to zero in 2020
- By the end of March 2020, an estimated 10% of loans held by CLO managers had had their credit ratings downgraded or announced a downgrade – but the rate of credit downgrades declined and stabilized in the second half of 2020
European CLOs experienced the worst of the cycle in 2020 despite COVID-19 uncertainty, rating downgrades and volatility in credit prices.
The European CLO new issuance volume in 2020 fell by 26% year-on-year to zero 22 billion in 2020.
Some may have feared the worst in March 2020 when leveraged loan prices collapsed, but CLOs have shown again (as after 2008) that they are designed to function smoothly through business cycles, to the point where we say that the events of 2020 turned out to be hardly a flesh wound for the CLO market.
While by the end of March the credit ratings of an estimated 10% of the loans held by CLO managers were either downgraded or a downgrade was announced, the rapid rebound in the leveraged loan market – combined with the ability of CLO managers to target higher-risk sectors and markets otherwise challenging positions – CLO portfolios have already recovered significantly, both from a rating and from an overcollateralization perspective.
Banks that provided CLO’s “stock” facilities – lines of credit that allow CLOs to buy up loan portfolios before they are tranchecked and sold on to investors – were also cautious in mid-2020 as investors’ appetite for buying up of CLO tranches waned. According to Financial Times, between 40 and 50 warehouse lines were outstanding by the end of March 2020.
However, there have been signs of recovery since the first round of COVID-19 restrictions were introduced in the summer: the primary CLO new issue market was back in full swing in October 2020 when CLO new issues reached 4 billion deals – the highest monthly level since October 2019. The liability spreads also narrowed in the course of the year, so that US dollar deals were marketed again in Europe.
The start of the vaccine launch in December 2020 has given markets around the world another boost, and the market expects the reset and refinancing activities to return to Europe in 2021, as it did in the US.
The resilience of CLOs is due in part to lessons learned from the 2008 financial crisis. Prior to the collapse of Lehman Brothers, which sparked the 2008 credit crunch, the CLO portfolios contained a higher proportion of high-yield bonds and managers had longer periods to reinvest interest payments and proceeds from existing portfolios in additional borrowing. These structures were called “CLO 1.0”.
However, beginning in 2010, the CLOs have been adjusted by narrowing the windows for reinvestment of proceeds, reducing or eliminating high yield bonds from asset pools, and strengthening credit quality and support. These post-credit crunch years were referred to as “CLO 2.0”.
CLOs have also performed well thanks to other product structure features, including the typical requirement that 90% of a portfolio include senior secured loans, portfolio diversification by borrower and by industry, restrictions on illiquid loans, and the increasing importance of ESG criteria that CLOs impose Have protected investments in riskier sectors.
COVID-19 has also sparked a new wave of CLO development. Although CLOs had some flexibility in restructuring, there were some limitations to the CLOs’ ability to follow their money when their underlying credit was in distress. In the past, this has put CLO managers at a disadvantage in restructuring situations compared to hedge funds, which are not subject to the same restrictions.
However, post-lockdown deals have started to adjust, giving CLOs more leeway to participate in bailout finance and restructuring. According to S&P Global, a recent deal by CLO manager CVC included documentation that allowed the company to acquire credit in default, bankruptcy or restructuring scenarios if the purpose was to mitigate losses. CLO managers Redding Ridge and GSO are said to have secured similar terms.
Immediately after the lockdown, CLOs also adapted by introducing short-term CLOs with a notice period of 12 months instead of two years in order to benefit from the sharp fall in credit prices in the secondary markets. Permira and Oaktree are among the managers who have quickly built portfolios of heavily discounted loans in the secondary market. In the fourth quarter of 2020, transactions were back on the typical two-year notice period, and shorter reinvestment periods also became a feature of activity.
A focus on sustainability
In the midst of adapting the CLO market to the immediate challenges posed by COVID-19, the industry has also made further progress in the areas of ESG and sustainability. CLOs are a major source of funding for the $ 100 trillion needed to meet the Sustainable Development Goals by 2030. Banks are accelerating their underwriting of sustainability-related loans, but must recycle their capital by bringing these loans into capital markets through CLOs.
The G20 White Paper on Sustainable Securitization (co-authored by White & Case) recommended that G20 central banks start buying sustainable assets. This recommendation was accepted by the European Central Bank from 2021 and paves the way for the next step in the growth of the market for sustainability-linked loans.
VodafoneZiggo’s initial green bond issuance in December 2020 is the latest example of the largest leveraged issuers joining the Sustainability Party and further evidence that this will continue to be a key driver of future CLO new issues.