The European CLO market is now certain to print the highest annual new-issue volume on record in 2021 — either before or since the global financial crisis — following a shift in focus toward new-issue deals, which market participants expect to carry over into next year.
In contrast to the first half of 2021 — when the market was awash with CLO resets and refinancings — new issuance has remained at the fore throughout the latter portion of the year, making up the lion's share of activity during the third and fourth quarters.
During the third quarter alone, European CLO new-issue volume totaled €10.53 billion, which is the highest for any quarter in the CLO 2.0 era, while €10.13 billion has already priced in the fourth quarter (to Nov. 24). This effort pushed the year-to-date CLO new-issue volume up to €35.78 billion, eclipsing the €35.49 billion priced in 2006 and notching up a new annual issuance record in the process, according to LCD data.
CLOs dominate single-Bs
The impact of this uptick in CLO new issuance on the leveraged loan market is clear, given the increasing correlation between the two markets (the European CLO market is the predominant investor segment in leveraged loans). Anecdotally, two loan syndicate desks suggested that CLOs have made up 90% of the buyer base of standard single-B-rated euro-denominated loans this year (i.e., those priced at 375-400 basis points area) with the trickier, higher-margin names attracting more non-CLO money. "An extra 100 bps tends to unlock sizable pockets of non-CLO liquidity," said one banker at a leading arranging house.
CLO demand also continues to underpin European secondary loans, with the average bid in the European Leveraged Loan Index currently close to yearly highs again, closing at 98.88 on Nov. 23, with single-B names at 99.29 and double-B names at 99.54.
Despite heightened demand from CLOs, primary loan pricing has remained disciplined and has even trended wider. For the three months ended Nov. 15, the average single-B term loan B spread rose to 421.56 bps, while the average CLO weighted average cost of capital, or WACC, was 182.26 bps, suggesting — on a rudimentary basis — an excess spread that surpasses the 200 bps said to be required to make CLO managers' equity arbitrage work.
However, views on the attractiveness of the arbitrage at any given point vary from manager to manager. "CLO arbitrage now is better than it was in January, despite liability spreads being wider, owing to the new-issue loan market," commented one manager.
A second manager disagrees, however, commenting that the arbitrage has been getting more difficult toward the end of the year: "There's the deals that everyone wants that come in tight, which isn't good for the arbitrage, and then there's the 30% of deals that you don't like — but that's where you get a good margin and [original issue discount]."
Depth of demand
Possibly the most significant development in the post-summer market, sources note, has been the depth in demand for triple-A CLO paper, with some going as far as to assess the current market for triple-As as being deeper than it was in the first quarter.
An increase in participation from triple-A investors taking smaller tickets — but not necessarily from smaller accounts — has allowed deals to be syndicated more widely since the late-summer break, which has offered managers a route to tighter pricing at the top of the stack, while those that locked in early for certainty of execution were unable to take advantage of the tightening market.
As of Nov. 24, three managers — namely CVC, Blackrock and Bridgepoint — had scooped triple-A coupons of 94 bps, the tightest level for a triple-A tranche, in the post-summer market.
Indeed, sources say that since the summer, the market has seen fewer anchor-driven deals, whereas before summer, anchor-driven deals dominated the European CLO landscape, with some anchors requiring higher coupons than others.
However, tightening spreads at the top of the stack have been tempered somewhat by the softening of mezzanine notes, given the weight of supply and the shallower pool of investors further down the capital stack.
As a result, the WACC on new-issue prints has broadly come in at a range of 179 bps to 192 bps since the start of the fourth quarter (excluding static vehicles and CLOs without a single-B-rated tranche), with a few outliers. The tightest print during that time frame was observed on the €447.5 million CVC Cordatus Loan Fund XXII, which came in at 179.5 bps, according to LCD, while the widest was the €355 million Nassau Euro CLO I (a debut European issue for the U.S.-based platform), which printed at a WACC of 202 bps, and with a triple-A coupon of 105 bps.
Screen test
Positive screening is the next item on the agenda in the European CLO space, with negative screening for environmental, social and governance factors in CLOs now firmly market standard in the form of eligibility criteria. ESG scoring — i.e., the scoring of borrowers based on their ESG credentials — is now reported by managers, undertaken but not reported, or in the process of being developed (either internally or alongside a third-party scoring provider).
One of the more recent European CLOs to have been highlighted for its positive ESG considerations is the €404.75 million Fidelity Grand Harbour CLO 2021-1 for FIL Investments International, which encompasses a portfolio test. Under the test, 50% of the portfolio has to be rated A-C from an internal score ranging from A to E that Fidelity applies across its entire platform, according to sources. The test is understood to be treated similarly to other CLO tests (such as the weighted average rating factor test) on a maintain or improve basis, sources note.
Fidelity Grand Harbour's CLO is understood to be aligned with Article 8 under Sustainable Financial Disclosure Regulation.
Great expectations
Given the relentless pace of CLO issuance throughout 2021, it remains to be seen whether the European market will maintain the same momentum going into December, in contrast to the U.S. market, which has a natural stop owing to the pending Libor deadline. While activity in Europe typically slows down for the year around the Thanksgiving holiday in the U.S., sources concur that there is plenty of supply still to come, with deals in the pipeline that could well push back market participants' Christmas party plans by a week or two.
Liability pricing will ultimately depend on how long CLO noteholders will continue investing, following an exceptionally busy year filled with record new issuance, resets and refinancings.
Such timings will also depend on loan market activity, amid some signs of a busy end to the year. "There's a chance on the asset side that syndication could run late into December, given the timing of Christmas this year," commented a CLO manager. "However, it would be difficult to launch as a brand new name now and allocate before the break," they added.
The balanced view is that the market will remain open into December, with a chance that pricing levels might widen. "We're seeing deals now at 95-98 bps area and I think we'll be in the mid-high 90s in a few weeks. If you want to price in December, then we know what will happen there," commented one arranger, who expects the market to remain focused on new issues into 2022.
"This year managers have been juggling their existing pipelines and addressing the cost of capital on existing deals. There are still resets in the pipeline, but as 2022 progresses the market will lean towards more new issuance," added the same manager.
There are currently an estimated 50-55 CLO warehouses open and ramping, while various market commentators expect European issuance to take center stage during the start of 2022, as the U.S. market transitions to the secured overnight financing rate.
On the macro front, despite growing negative headlines, market participants point to very few headwinds that could filter through to the leveraged loan and CLO markets in the near-term, with those that have spoken to LCD more concerned about the risk of sourcing assets while remaining bullish on default and recovery rates.
Indeed, volatility in wider markets, including the high-yield asset class, in October did not filter through to the CLO liability market, which sources note was another indicator of investors' preference for the floating-rate nature of the product.
Nevertheless, there remains mixed views on inflationary and supply chain risks going forward as well as the extent to which these have been reflected in companies' third-quarter results. "I don't expect portfolio stats to improve next year. While there won't be a wave of defaults, there will be more volatility and the wave of upgrades that people are expecting will take longer," said one manager.
From a structural standpoint, delays to loan settlements will remain an area of interest going into 2022, with multiple managers now concurring that increased delays are having a material impact on their CLO distributions.
One outcome from this dynamic is a potentially tiering affect between those better able to manage delayed loan payments and those that are less well-equipped, with larger and more-established managers arguably better positioned to leverage their size and profile to chase down and speed up delayed payments.