October 2018

With record issuance of EUR20.8 billion and more to come, Deutsche Bank research explains why 2018 has been a stellar year for collateralised loan obligations

It’s only October but 2018 has already been a record year for collateralised loan obligation (CLO) issuance in Europe. The latest Deutsche Bank research on the market notes that EUR20billion of post-crisis CLOs, or CLO 2.0s, have already been issued this year1 (see figure 1)This issuance is driven by both demand and supply.

 

Figure 1: Historical CLO issuance

On the supply side, the issuance of leveraged loans has picked up markedly in Europe driven by improving economic conditions and healthy financial sponsor activity. These contributed to an estimated supply of EUR67billion in institutional loans as of the end of September 2018. While on the demand side, investors continue to hunt for yield. The investor base of both European and non-European investors has also become more diverse as momentum gathers. 

“It’s been a very good year for CLOs and underlying loan issuance has remained supportive,” notes Rachit Prasad, Deutsche Bank Research Analyst and co-author of the bank’s monthly securitisation report. “We upped our full year forecast to EUR25-27 billion in August,” he said.

This momentum has been underscored by a record number of debut managers. The number of managers jumped from 41 in 2017 to 45 in 2018. If all the new manager deals price this year, this would take the debut manager list to 10. Some 24 deals are in the CLO new issue pipeline, but not all are near term candidates for pricing. Notably, some six debut Euro CLO 2.0 managers are in the list.

However on the back of strong supply, spreads for AAAs (discount margin) have widened to the c.100 bps area, but spreads are also significantly driven by manager reputation and/ or anchor investor presence (see figure 2).

Figure 2
Figure 2: Weighted average discount margin of CLOs issuance since 2017
Recently, with institutional loan spreads tighter but CLO liability spreads continuing to stay soft, the CLO equity arbitrage for new issues is getting increasingly tighter. However such variation in arbitrage has been seen in the past and typically the pace of new supply adjusts for this to self-correct. Elsewhere, Deutsche Bank’s research team also notes how such increased liability spreads have meant that the pace of resets could slow down as resets become uneconomical but more refis could be seen instead.

Where do we go from here?

Amidst all of these drivers, the larger fundamentals driving CLO issuance are set to continue in the medium term. Financial sponsor activity and continued demand by investors should prove supportive for the asset class over the medium term, with the European Central Bank’s QE exit and the possibility of a no-deal Brexit being tail risks2.

In terms of secondary trading, most activity is from post crisis CLOs as the legacy (pre crisis) market has largely matured or been called.

Reporting challenges ahead, but not insurmountable

From a regulatory standpoint, the European Securities and Markets Authority’s (ESMA) proposals on how CLO managers should report their underlying loans comes into effect on 1 January 2019. However, following the introduction of the templates on this date, ESMA has recommended that a 15-18 month transition period be allowed before these are implemented, to allow for IT systems to be set up.

Following a consultation (Draft technical standards on disclosure requirements, operational standards, and access conditions under the Securitisation Regulation3) with the industry, it was concluded that legacy CLOs will be exempt and this will only affect deals issued from 1 January 2019. In essence ESMA’s new reporting template proposes a new set of criteria (technical standards) for reporting CLO performance. Article 7 of the Securitisation Regulation contains the transparency requirements and directs the originator, sponsor or Issuer/SPV of a securitisation to make certain prescribed information available to investors.

CLO disclosures are classified into the following: 

  1. underlying exposures template, based off the corporate exposure template, which contains the information on each underlying loan; 
  2. investor report template reflecting data on the current state of the transaction 
  3. inside information template and 
  4. significant events template – these last two templates contingent on certain highlights to prevent market abuse and to keep investors informed of important developments with regard to the transaction respectively

While broadly the reporting templates are in line with what is already being used by managers, the incremental burden for CLOs needs some attention, notes the report. ESMA's underlying exposure template consists of 121 fields (for each underlying exposure), but 90 of these allow a "ND" (no data) provision of some kind. A large number of data gathering is needed for field 31, most of which are already captured in the current investor reports.

ESMA acknowledged that details on origination which have been requested can be difficult to fill out for CLOs as loans are traded in the secondary market. Nevertheless, it expects the reporting requirements to be met as - "although such information may be challenging to retrieve at first, then by the time that the reporting requirements fully apply, it appears that this information would be able to be made available in a sufficiently broad manner”.

In summary, the market is expected to adapt to the new requirements as there is a significant period of time before it comes into force. Any feedback from managers will continue to reach the European Commission before it gets adopted as law, and therefore there is still a chance for minor amendments to the text. Overall, Deutsche Bank’s research team expects the market to adapt to the new requirements over time.

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