Covid-19 put the European CLO market on a roller coaster ride. After a steep drop in Q2/Q3 2020, new-issue volumes rose sharply. Helped by soaring leveraged loan issuance, over EUR 10bn of CLOs came to the market in each of Q3 and Q4 2021, pushing new issuance up by about 70% yoy, a new post-GFC high. Annual supply of EUR 39bn was a full-year post-GFC record. Refinancing and reset transactions also surged, totalling nearly EUR 61bn as managers profited from more favourable market conditions than in 2020.

“Investors that shied away from the market in 2020 have mostly returned and appetite keeps growing. The surge shows no sign of slowing,” said Benoit Vasseur, executive director in Scope’s structured finance team.

Heavy primary supply forced CLO spreads wider across the capital structure, back to pre-pandemic levels. Spread arbitrage is still relatively high at around 185bp, though it has shrunk compared to the beginning of 2021. “While tighter spread arbitrage is likely to leave investors at the bottom of the capital structure with tough choices, managers may be forced to build more aggressive CLO structures with riskier assets to enhance spreads,” Vasseur continued.

“Tight spread arbitrage presented a number of incentives for CLO managers to invest in riskier portfolios, making structures more vulnerable to deteriorating asset quality. The expected end of the low-rate environment has added more uncertainty to leveraged loan and CLO markets,” he said.

A sharp rate rise could put the debt servicing and refinancing capacities of high-yield borrowers under pressure. Borrowers with high indebtedness and weak balance sheets could see increased rating downgrades and defaults, which could put CLO structures under stress with possible breaches of over-collateralisation tests and deferred interest for junior tranches.

The higher yields available on private credit (direct lending) could relax the tight arbitrage. Scope expects increased appetite among CLO managers for private credit in the form of middle-market loans; the number of private credit deals, particularly direct lending, is growing ever larger.

Leveraged loan markets are making progress on transitioning from Libor to risk-free rates. But European CLO managers may find investing in non-euro-denominated assets difficult as asset-swap hedges will need to mirror the changes in asset reference rates. Mismatches between asset and liability reference rates are likely to increase.

“ESG momentum is accelerating. Negative screening has become mainstream and we expect CLO managers to develop positive screening strategies and incorporate more sustainability criteria into their decision making, aiming at the widening ESG-conscious investor base,” said Vasseur.

Download the report here.

And join Scope for an Outlook for European CLOs Webinar at 15:30 CET on Wednesday February 2, where Benoit Vasseur will review European CLO activity in a very busy 2021 and comment on the key themes in what we expect to be another busy year ahead. Register now.