Issuance Set To Bounce Back Modestly From Multi-Year Lows

After a strong start to 2020, investor-placed European securitization issuance stalled due to the coronavirus pandemic and ended the year down by 33% at €68 billion--the lowest annual total since 2013 (see chart 1). Issuance could bounce back from this low base to €75 billion in 2021, assuming a successful rollout of vaccines and an associated easing of restrictions and economic recovery. European benchmark covered bond issuance also declined 34% to €87 billion in 2020. An increase in scheduled covered bond redemptions could support a muted recovery in volumes to €100 billion, despite issuers' continued access to cheaper funding alternatives.

Although structured finance volumes may rise in 2021, they will likely remain depressed compared with recent years prior to 2020. We believe wholesale funding issuance will benefit from continued steady growth in underlying lending to the real economy. However, the extraordinary monetary policy response to the pandemic included renewed liquidity provision from central banks, which will likely dampen the supply of both covered bonds and bank-originated securitizations throughout 2021.

Chart 1

Although European securitization volumes declined across countries and sectors in 2020, new issuance diversity increased as niche sectors saw relatively lower volume declines than the combined 40% drop seen in the three core areas of leveraged loan collateralized loan obligations (CLOs), U.K. residential mortgage-backed securities (RMBS), and German auto asset-backed securities (ABS). For instance, RMBS volumes outside the U.K. and Netherlands fell only 22%. Meanwhile, auto ABS issuance outside France, Germany, and the U.K. increased 8% and returned in Greece, Ireland, the Netherlands, and Portugal following no activity in 2019. Despite the challenging backdrop, Spanish securitization issuance also saw a second consecutive year of growth, with investor-placed volumes increasing 25% to over €4 billion—the highest level since the 2008 financial crisis.

CLOs remained the highest-issuance sector in 2020, despite recording a 40% decline after four successive years of growth. We believe CLO volumes could recover to about €25 billion in 2021, given a likely uptick in underlying leveraged loan originations and improving transaction economics. These issuance figures do not include CLO refinancings and resets, which accounted for significant additional activity in 2017-2019 but very little in 2020, as liability spreads widened and CLO managers had no incentive to refinance or reset transactions that exited their non-call periods. In 2021, however, we expect a significant uptick in refinancings and resets, especially because many 2020 vintage CLOs were structured with short non-call periods in anticipation of a trend toward lower financing costs, which has subsequently materialized.

Benchmark covered bond issuance declined in most markets, except in France, where volumes rose 5% to more than €27 billion. German issuance fell to under €20 billion for the first time since 2017, and the U.K. market, which had the third-largest issuance in 2019, saw volumes drop by nearly 60% in 2020.

Revived Central Bank Funding Schemes Set To Stifle Bank-Originated Structured Finance

Bank-originated European structured finance volumes have been depressed for several years due to the availability of cheaper funding options from the European Central Bank (ECB) and the Bank of England. While some of these schemes had been gradually winding down, the monetary policy response to the coronavirus pandemic saw central banks revive their large-scale provision of cheap term funding for credit institutions, which will likely stifle bank-originated structured finance supply once again.

Throughout the pandemic, underlying bank lending to households and nonfinancial corporates in the U.K. and the eurozone remained resilient with low-single-digit annual growth rates. This supports net issuance of wholesale funding, potentially including securitizations and covered bonds, though these products' share of the overall funding mix will partly depend on the availability and cost of issuers' central bank alternatives.

In the U.K., the approaching maturity of some originators' borrowings from official sector funding schemes had promised to spur growth in bank-originated structured finance through 2020 and beyond. However, in March 2020, the Bank of England relaunched its Term Funding Scheme, now dubbed the TFSME. This contributed to lower U.K. covered bond and bank-originated securitization supply in 2020, with financial institutions drawing down nearly £70 billion from the new scheme during the year (see chart 2). The ECB loosened the terms of its equivalent scheme of targeted longer-term refinancing operations (TLTROs), leading to a similar effect in the eurozone. Most recently, in early December, the ECB scheme was again extended to provide funding until the end of 2024. The ECB also raised the amount banks can borrow under the scheme by 10% and extended the timeframe for application of the most favorable borrowing rate.

Chart 2

Although issuers will likely substitute this central bank funding for some European covered bond issuance, they may still find covered bonds an attractive method to fund at longer maturities. In addition, scheduled covered bond redemptions are set to increase nearly 10% in 2021, so gross volumes could still increase 10%-15%, in our view, even assuming net issuance remains modestly negative. Another potential positive for the covered bond sector is that the European Union's legislative package to better harmonize the region's covered bond markets should be transposed into member states' national laws by July 2021, with the new measures going into effect by July 2022. However, we see an increasing risk that the project could be delayed in some countries due to changes in legislative focus to support recovery from the pandemic.

In the European securitization market, although long-running regulatory projects generally moved further from the spotlight in 2020, progress was made on the EU's Securitization Regulation, as key technical standards came into force during the year, including those on disclosure requirements. However, some market infrastructure that the regulations ultimately require is still under development, such as transaction data repositories. Additionally, some proposed amendments to the Securitization Regulation and related bank capital requirement rules were included in a fast-tracked legislative package in 2020 and would extend the "simple, transparent, and standardized" (STS) quality label to securitizations that are structured synthetically. This could facilitate more widespread use of securitization as a balance sheet management tool and spur more issuance in the longer term.

We also expect the European securitization markets will see some changes following the end of the Brexit transition period on Dec. 31, 2020. Notably, the EU27 and U.K. regulatory frameworks no longer have full reciprocal recognition for securitizations, meaning that U.K. transactions can no longer carry the EU's incarnation of the STS label. This will lead to some EU investors facing higher regulatory capital charges on U.K. securitization exposures.

Credit Stress May Develop As Support Schemes End

We expect European structured finance credit performance to remain under pressure in 2021. With COVID-19 infection rates still high and governments enacting tighter restrictions, the road to recovery will remain bumpy until effective vaccines become widely available. We believe the economic damage from the pandemic will become clearer through 2021, once a recovery takes hold and fiscal support starts to be scaled back.

Since March 2020 and the onset of the COVID-19 pandemic in Europe, we have lowered just over 3% of our ratings on structured finance securities in the region. Commercial mortgage-backed securities (CMBS) transactions backed by retail and hotel real estate have been most affected, along with corporate securitizations linked to leisure businesses, but these sectors constitute a small portion of our outstanding European securitization ratings.

For most asset classes, the 12-month trailing average change in credit quality has been positive for several years, indicating aggregate upward ratings movements, though the trend weakened in 2020 (see chart 3). This measure highlights the CMBS sector's weaker credit performance, where ratings moved lower by an average of 0.5 notches during the 12 months ended September 2020.

Chart 3

Ahead of final annual data, we believe the eurozone economy shrunk by more than 7% in 2020 but forecast a rebound of about 5% in 2021. The ECB is set to keep its policy rates lower for longer and extend its asset purchases, given inflationary pressures are unlikely to build in the short term. We also expect the eurozone unemployment rate to increase by less than one percentage point to 8.7% in 2021, which would place limited pressure on consumer-related assets backing eurozone securitizations and covered bonds, and we forecast a recovery to the pre-pandemic unemployment rate of 7.6% by the end of 2023 (see chart 4). U.K. workers are likely to be relatively harder hit, with a two-percentage-point increase in unemployment to 6.7% in 2021 and a slower recovery than in the eurozone, partly due to additional pressures surrounding Brexit.

Chart 4

For sectors backed by consumer lending, the underlying borrowers have benefited from both income support through furlough schemes and reduced outgoings through payment holidays. Many of these schemes were extended in late 2020, following the second wave of lockdowns, but we expect collateral performance will eventually deteriorate in the second half of 2021 as support measures come to an end and unemployment increases. For corporate-backed transactions, there remains some downside risk to ratings if credit distress among underlying borrowers increases this year. For example, we forecast the annualized default rate for European speculative-grade corporates could rise to 8% by September 2021. The impact for European CLO ratings will partly depend on how well collateral managers are able to continue mitigating credit deterioration through trading activity.

We don't foresee any negative effect on the fundamental functioning of European structured finance transactions due to the conclusion of U.K.-EU trade negotiations. Instead, given the diverse collateral backing European securitizations and covered bonds, we anticipate that any effects due to the Brexit outcome will be felt more gradually as wider macroeconomic implications filter through to underlying credit performance. U.K. housing will be one area of focus, although any incremental stress due to Brexit may prove insignificant relative to the pandemic's impact and the eventual end of associated fiscal and monetary support.

Appendix: Sector-By-Sector Outlook Highlights In Charts

CLO

Chart 5

• New European CLO issuance declined by 26% to €22 billion in 2020, following four consecutive years of growth.
• There was also hardly any refinancing and reset activity, given little economic incentive for managers and equityholders as CLO liability spreads widened in the face of the COVID-19 pandemic.
• However, many CLOs that closed in 2020 were structured with short non-call periods in anticipation of lower funding costs and the possibility of refinancing in the near term.

Chart 6

• By the end of 2021, 2017-2020 vintage CLOs with an original volume of €85 billion will have reached the end of their non-call periods.
• If CLO liability spreads continue to tighten, managers of many outstanding transactions--especially from the 2019 and 2020 vintages--could have an incentive to refinance or reset them.
• Some CLOs may become reset candidates even if their original liability costs are somewhat lower than current market rates. For example, some managers may prefer to reset a transaction around the end of its reinvestment period in order to continue reinvesting on an existing platform, rather than allowing the transaction to amortize.

Chart 7

• Discount margins on newly-issued CLO tranches widened sharply across the capital structure through the first half of 2020.
• However, some transactions closing toward year-end saw their senior tranches pricing at 105-110 basis points (bps), which is again close to pre-pandemic levels.
• The last five transactions to price at the end of 2020 had a median weighted-average cost of funding (WACF) of 193 bps, which is lower than €29 billion of outstanding CLOs that will leave their non-call periods before end-2021.

Chart 8

• The trend in new CLO issuance has historically been closely linked to the trend in underlying leveraged loan originations.
• Annualized European leveraged loan origination volumes have fallen by more than 50% over the past three years, exacerbated in 2020 by the COVID-19 pandemic.
• However, lending activity looks set to recover in 2021 on the back of increased M&A and buyout activity, which could support a rise in new CLO issuance.

Chart 9

• The credit quality of assets backing European CLOs generally deteriorated following the onset of the COVID-19 pandemic but has since stabilized.
• Across the European CLOs that we rate, the median exposure to obligors rated in the 'CCC' category has for now settled at about 7%.
• However, this statistic varies substantially between transactions and, in many transactions, is still higher than the 7.5% threshold above which some assets are carried at market value in overcollateralization test ratios.

Chart 10

• The proportion of underlying assets backing European CLOs that are on CreditWatch negative provides an indication of exposure to downgrade risk in the short term.
• Across the European CLOs that we rate, the median exposure to obligors whose ratings are on CreditWatch negative has normalized to 3%--almost back to pre-pandemic levels.
• This change in portfolio composition has partly been driven by CLO managers actively trading out of weaker corporate credits and sectors and redeploying proceeds into more defensive exposures.

ABS

Chart 11

• While investor-placed European ABS volumes declined by more than a quarter in 2020, the composition of issuance remained diverse.
• Volumes in the Spanish auto ABS sector more than doubled to €3.3 billion--the highest level since the 2008 financial crisis.
• In 2021, we expect some recovery in issuance from core sectors such as German auto ABS, which slowed disproportionately in 2020.

Chart 12

• More than 20% of European ABS tranches (by count) placed with investors in 2020 were rated in the 'BB' category or lower.
• Some originators have continued the trend toward selling the full capital structure of their ABS transactions, rather than retaining the higher-risk portions.
• This could signal a return to the use of securitization for capital relief--rather than solely as a funding tool--spurring issuance growth.

Chart 13

• For consumer ABS, growth in banks' underlying lending activity should generally support issuance.
• The rate of net lending fell sharply through 2020 in the face of the COVID-19 pandemic but could bounce back in 2021 as economic conditions begin to normalize throughout the year.
• This could support a corresponding issuance recovery in consumer-related ABS sectors, notwithstanding originators' access to other funding tools, including central bank schemes.

Chart 14

• Our delinquencies indices aggregate credit metrics across the underlying collateral pools of transactions that we rate.
• However, the effect of various borrower support schemes and differing originator reporting practices are likely masking the underlying credit trends, which should become more apparent through 2021.
• We see the continued high level of 90+ day delinquencies—together with our forecast of rising unemployment—as indicators of higher defaults in 2021.

Chart 15

• The trend in used vehicle prices may be a significant credit consideration in auto ABS transactions exposed to residual value risk.
• Market data suggests that used car prices in most auto ABS markets have generally benefited from the COVID-19 pandemic, rather than the opposite.
• We expect that this trend could reverse as economic pressures continue, although the impact on existing auto ABS transactions with residual value risk could be muted, given the strong position those markets are currently in.

RMBS

Chart 16

• Investor-placed European RMBS issuance slowed by 38% in 2020, with activity declining in most countries, although volumes did increase in France and Spain.
• In the largest market—the U.K.—there was little activity among traditional master trust platforms.
• RMBS issuance could recover modestly in 2021, given likely pent-up demand for housing transactions and ongoing growth in underlying mortgage lending.

Chart 17

• Non-bank originators dominated the RMBS sector again in 2020, with less than 35% of issuance from bank originators, compared with more than 90% in 2012, for example.
• In the U.K., maturing legacy central bank funding was largely rolled over into the Bank of England's new TFSME scheme, rather than being refinanced using RMBS.
• Across Europe, such revamped central bank funding schemes will likely continue to stifle bank-originated RMBS supply in 2021.

Chart 18

• On average, severe delinquencies reported for the mortgage pools backing RMBS that we rate have risen only modestly since the onset of the COVID-19 pandemic.
• However, given the variety of borrower support measures across countries and potentially differing reporting practices between lenders and RMBS servicers, these figures may mask the underlying credit trends.
• We anticipate that mortgage pool performance will become clearer in the second half of 2021 as support measures come to an end.

Chart 19

• Take-up of payment deferrals has varied significantly between countries and lenders, due to different eligibility criteria and application processes.
• However, in many RMBS transactions that we rate, the prevalence of deferrals has reduced significantly since the initial peak in early to mid-2020.
• That said, deferral schemes have generally been extended in line with extensions to social restrictions, so uptake could rise again, but even if receipts drop substantially, most RMBS transactions can cover several periods of bond payments.

Chart 20

• House prices in most European markets remained fairly buoyant in 2020, despite COVID-19 lockdowns and an unprecedented drop in economic activity.
• We forecast a moderate house price slowdown for many countries in 2021 as pandemic-related government support is phased out and labor market developments become less supportive of household income.
• A return to pre-pandemic levels of activity in 2022, and potential structural changes in housing demand after COVID-19, should lead to a renewed acceleration in housing demand and prices, in our view.

CMBS

Chart 21

• CMBS volumes fell back to less than €2 billion in 2020, with only five transactions closing.
• Both pound sterling and euro issuance declined to their lowest levels since 2017.
• This drop in issuance mainly resulted from uncertainty around property-level cash flows for retail and hotel assets, which accounted for a large portion of CMBS issuance in recent years.

Chart 22

• The geographical diversity of European CMBS issuance declined significantly in 2020, with no transactions from several countries that saw activity the previous year (e.g. Germany, Italy, Ireland).
• U.K. issuance still made up more than a third of the total despite uncertainties surrounding Brexit.
• Issuance has been focused on more predictable assets, given that the pandemic has raised questions about the value-sustaining capabilities of some commercial property types.

Chart 23

• In 2020, the average change in credit quality for European CMBS turned more negative, with our ratings in the sector moving lower by an average of 0.5 notches in the 12 months to end-September.
• Credit distress caused by the COVID-19 pandemic and other longer-standing pressures in retail real estate led to a downgrade rate of more than 15% in the first nine months of 2020, almost entirely affecting tranches backed by retail and hotel properties.
• We expect continuing downward pressure on rents—and consequently properties values—in the retail segment. In hotel markets, the speed of the recovery over the next two to three years will depend on how long travel restrictions and social distancing measures continue.

Related Research

• Global Structured Finance Outlook 2021: Market Resilience Could Bring Over $1 Trillion In New Issuance, Jan. 8, 2021
• CLO Pulse Q3 2020: Sector Averages Of Reinvesting European CLO Assets, Jan. 6, 2021
• Dutch RMBS Index Report Q3 2020, Dec. 11, 2020
• European RMBS Index Report Q3 2020, Dec. 11, 2020
• Italian RMBS Index Report Q3 2020, Dec. 11, 2020
• Spanish RMBS Index Report Q3 2020, Dec. 11, 2020
• U.K. RMBS Index Report Q3 2020, Dec. 11, 2020
• European Auto ABS Index Report Q3 2020, Dec. 9, 2020
• European And U.K. Credit Card ABS Index Report Q3 2020, Dec. 9, 2020
• Credit Conditions Europe: Waiting For Relief, Dec. 3, 2020
• Economic Research: The Eurozone Can Still Rebound In 2021 After Lighter Lockdowns, Dec. 1, 2020
• Covered Bonds 2021 Outlook: Policy Intervention Is Reshaping The Role Of Covered Bonds, Nov. 25, 2020