The past year was challenging for the European CLO market and its participants. The level of uncertainty was exemplified by the span of 45 days over March and April without issuance, one of the longest shutdown periods since the market reopened in 2013. The market eventually recovered and saw roughly EUR 21bn of issuance, albeit that was down 31% year-on-year. Q4 issuance was noteworthy as it was in line with volumes observed in 2019, despite a significantly lower average notional per transaction.

“The decrease in the notional of single transactions is one of many changes observed in CLO structures since the start of the pandemic,” said Benoit Vasseur, an Executive Director in Scope’s structured finance team in a report out today. “Fluctuating investor demand and the relative scarcity of adequate collateral has forced CLO managers to issue shorter and less levered transactions. This trend should continue as long as global uncertainties persist.”

For 2021, the outlook is mixed. On one hand, recent months have been reassuring in terms of issuance. The fourth quarter saw the highest number of single transactions come to the market since the Global Financial Crisis. Managers successfully met prevailing demand for CLOs while still offering attractive relative value compared to most other credit markets.

“Managers were able to do this by including features that had been explored in certain pre-Covid transactions, such as the removal of single B rated tranches, leading to managers retaining more equity; shorter reinvestment periods; and one-year non-call periods,” said Cyrus Mohadjer, senior structured finance analyst at Scope. “The average notional per transaction is still relatively low, even though we have observed a slight increase compared to Q2 and Q3 2020. We consider this supportive entering 2021.”

On the downside, there is rising pressure on the asset side of the equation as leveraged loan issuance continues to be sluggish while asset quality has deteriorated. The unwinding of government support packages could trigger a spike in corporate defaults, particularly at the bottom end of the rating scale.

In addition to primary issuance volumes, other indicators are trending back towards pre-Covid levels in transactions issued recently, such as credit support and primary spreads, especially at the AAA level. Sub-investment-grade tranches continue to be impacted, as the risk premium requested by investors is among the highest since 2014. “This suggests a resurgence of idiosyncratic risk over the systemic risk we have witnessed since March,” said Vasseur.

Managers have been increasingly exploring ways to incorporate ESG elements. In the future, we expect more positive selection rather than exclusion of certain assets based on ESG criteria. A Scope study into ESG impact found that the 50 most frequent leveraged loan issuers perform slightly better than the 70 firms in the CAC 40 and DAX 30 indexes.

Download the report here.