Early year forecasts for the European CLO market point to familiar issuance conditions, with questions over what will move the dial for volume in the asset class. However, managers are heartened by an anticipated increase in CLO prepayments, which could drive renewed demand for new issuance and push spreads tighter.
LCD counts 66 managers that have priced a CLO in Europe since 2018 — adjusting for platform consolidations — while this year only 44 managers have issued, with those that are unable to finance their own equity or those without risk-retention funds facing greater challenges when it comes to printing, given a prevailing lack of third-party equity demand.
The question then is whether traditional CLO equity arbitrage is likely to meaningfully improve over the coming quarters, thereby opening up issuance to all CLO managers and expanding the universe of potential CLO resets.
Ultimately, the fundamental driving force for improved CLO issuance conditions will be new loan supply, for which there is no great expectation that buyout-related activity will pick up meaningfully — at least not during the first six months of 2024.
However, drivers to the upside across credit markets in general include greater clarity over rates and inflation — at least, for now — and a consensus that default rates in the leveraged loan universe will increase but are likely to remain within historical averages.
Volume projections flat
As of Dec. 13, €25.82 billion of CLO issuance had priced in Europe in 2023, with at least one more deal expected to clear the market before year-end. “The CLO market was more resilient than expected in terms of new issuance. With headwinds including geopolitical, macroeconomic and inflation, it was an impressive year in that sense,” said Sandeep Chana, director of structured credit at S&P Global Ratings.
Across bank research desks, forecasts broadly suggest more of the same in 2024, with most projections landing in line with this year’s volume. At the more optimistic end of the spectrum, both BofA Securities and Deutsche Bank forecast €27 billion of gross new-issue CLO supply, while JP Morgan, BNP Paribas and Morgan Stanley estimate €25 billion.
Such projections track roughly in line with the five-year volume average of €25.25 billion (2017-2022, excluding 2021). However, at the lower end, Barclays expects issuance to fall to €20 billion, with CLO equity returns “likely to remain challenged by elevated yields of CLO debt, a less attractive arb and an elevated loan default environment,” according to the bank.
Fewer warehouses
According to market participants, the number of open warehouses would appear historically light at present, with most estimates ranging from 30 to 50 warehouses — including those with permanent warehouses and those managers with multiple warehouses open, although participants concur that the latter cohort is likely to be small.
With this in mind, those managers with access to internal equity that have been able to issue in the challenged equity arbitrage environment over the last two years are logically more likely to have a warehouse open. “Warehouses are historically low given there are very few banks that will open a warehouse with a manager that doesn’t have a solution to the equity — even if you’re a well-liked, established manager. So limited demand for primary equity can explain why there are a little less warehouses open,” explained one manager.
“The number of open warehouses is likely less as a result of new-issue loan volume being lower, risk-retention funds not participating in warehouses, and less competition from fewer people participating in warehouse equity,” concurred an investor. “Also, managers are less inclined to open warehouses at the current economics as the arbitrage doesn’t work and there’s a drag from no performance fees.”
Managers have also expressed hesitancy to open a new warehouse and start a two-year countdown to price in what remains an uncertain market. The fundraising environment meanwhile remains tricky for those raising funds to take down their own equity.
“The arb is not great at the moment and some managers with captive equity may start to run out,” said David Nochimowski, head of global CLO & ABS strategy at BNP Paribas. “However warehouse volume should follow CLO volume, so I wouldn’t read too much into current warehouse openings, given we’re at the end of the year and we’ve already seen a lot of issuance. We’re at a time now when things slow down.”
But banks are still active, and for those managers with a realistic chance of printing, warehouse conditions on offer are said to be competitive. This includes a palatable cost of leverage and two-year tenors, according to managers lining up deals for next year.
Resets to pick up
Away from new issues, CLO resets are expected to pick up in 2024 without any significant improvement to the CLO economics. In terms of reset volume, Morgan Stanley is forecasting €7-10 billion, BNP Paribas is forecasting €10 billion, and BofA Securities is anticipating €12 billion of reset and refinancing activity. “We think resets will make a comeback and total €7-10bn, mostly from mid-to-late 2022 vintages. That might change to the upside, with more deals amortizing that may choose to reissue or reset,” commented S&P’s Chana.
Under the assumption there will be no meaningful tightening in liabilities, 2022 and 2023 vintages that are still within their reinvestment periods will make up the vast majority of potential reset candidates in 2024.
As a rudimentary calculation, there are 27 CLO deals totalling €10 billion with triple-A coupons of 180 bps or higher that will exit their non-call periods next year. Of this supply, roughly €6 billion priced in 2022 and €4 billion printed in 2023, according to LCD.
Breaking down these CLOs further, €1.8 billion rolls off in the first quarter of 2024, €2.5 billion rolls off in the second quarter, €1.8 billion rolls off in the third quarter, and €3.9 billion rolls off in the fourth quarter — which is when 2023 deals come through in earnest.
As a rough calculation — and only looking at deals exiting their non-call periods next year — should triple-A liabilities tighten below 160 bps, then the potential pipeline increases by almost €5 billion.
Prepayments: a saving grace
From a debt investor’s perspective, all-in yields have remained historically attractive this year. However, from the viewpoint of managers, there are few drivers on the horizon that could move the dial to any significant degree to improve the equity arbitrage.
“If you look at triple-A paper in secondary, there has been some tightening to 170 bps, so right now there is some momentum there, maybe into the 160s, but I wouldn’t expect any massive tightening,” commented a second CLO manager.
However, a number of managers already in discussions to print in 2024 have spoken with optimism regarding the possibility of at least some liability tightening, and not just on the back of new budgets being approved at the start of the year.
Over the past few months, new investors are understood to have participated on triple-As, while managers have highlighted an uptick in enquiries, specifically from regional banks in Europe. This includes institutions in the DACH region, Greek banks (already active over the past few years) and Spanish banks. Bank treasuries are also understood to be expanding their investment strategies, with certain arranging banks with the balance sheet to do so starting to take down triple-As not just on their own deals, but on other transactions too — on the basis that it is an attractive trade at current levels.
“The situation is getting better, as loans are getting tighter and triple-A spreads could tighten to 150 bps, and if that transpires then we’ll see resets of 2022-2023 deals that are 180 bps and over,” said the first manager. “We’ll also see more CLO amortisations and 2014, 2015 and 2016 CLOs called with no economic case to reset. Called CLOs will be a saving grace on the liability side, as triple-A investors — specifically banks — can get cash back from deals paying sub-100 bps and reinvest at current levels.”
Rather than a significant amount of new money flooding into the market, for now it is older vintages that are out the money that are expected to provide a positive dynamic to the CLO technical in 2024. “The expected increase in loan repayment rates next year as a result of the nearing maturity wall should translate into faster deleveraging speeds for CLOs that are out of their reinvestment period,” said BNP’s Nochimowski.
“People focus on 40% of CLOs being out of their reinvestment periods, but despite this there has been limited prepayment over the last year, which has coincided with a limited prepayment in loans. Higher prepayments next year will facilitate the natural way to issue new CLOs,” said a third manager.
Importantly, higher repayments could also spur more activity from Japanese investors, managers hope — however, demand there is also driven by currency rates and the outlook over the European economy.
A private credit CLO for 2024?
According to a recent LCD survey, despite considerable hurdles still to overcome, 81% of market respondents said the emergence of a private credit CLO in Europe would be a 2024 event. This view reflects a growing level of optimism over the course of 2023, specifically from a limited number of arrangers, regarding the appearance of such a vehicle on this side of the Atlantic in the near future.
For a purely private credit vehicle, the barriers in the way of new deal formation are well documented, and include the challenge of sourcing assets at sufficient size and diversity, currency hurdles due to a significant portion of European private credit being denominated in sterling, and — perhaps most significantly — the question of how such vehicles would be rated.
While a broadly syndicated loan CLO in Europe might have upwards of 120 obligors, market participants note that a European middle-market CLO would realistically include half that amount, with the vehicle likely requiring higher subordination and wider spreads.
The second point of entry here for European CLOs then becomes the ability for managers to take on private credit in broadly syndicated loan CLOs — a point which may have already started to emerge in documentation on recent deals, through the inclusion of defined capacity for both private rating and credit estimate obligations in portfolio profile tests.
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