As the CLO market returns to pre-crisis levels of activity, managers and investors are getting more involved, helped by service providers who are able to deliver streamlined portfolio administration, as well as improved productivity and cost control
2017 was a good year for the collateralised loan obligation (CLO) markets, which saw volumes hitting post-crisis highs across new issuances and refinancings. A number of supply side and demand side factors drove this level of activity, including improved economic fundamentals across the US and Europe, healthy pipelines of leveraged loans related to financial sponsor activity and the continued hunt for yield by investors. At the end of 2017, new CLO issuance reached USD120bn in the US and EUR 20bn in Europe, setting post-crisis record across both markets 1.
The hunt for yield
On the investor side, appetite for CLOs has continued notwithstanding the Federal Reserve’s interest rate hikes and expected European Central Bank (ECB) tapering, with demand supported by CLO floating-rate structures (vs. fixed rate asset classes such ABS) and low historic default rates. This in turn drove CLO note spread compression across the capital stack, with US BBB spreads declining from an average of 400 bps at the start of 2017 to 250bps by year end, while AAA tranche yields declined from ~150bps towards the 100bps mark.
An additional factor supporting the ‘demand-side’ has been the continued and increasing interest from international investors. These investors’ search for yield and portfolio diversification ensures healthy demand as the supply of CLOs continues to grow. Despite an expected ‘tapering’ of quantitative easing (“QE”) in Europe, no policy rate rises are expected for the next 12 months, ensuring investors’ hunt for yield will continue.
US vs Europe
Notwithstanding the shared broad dynamics, CLO markets also retain some marked differences between the US and Europe. In the US, they have grown steadily since 2011. As the recovery gathered pace, new CLO issuance entered a multi-year cyclical upswing that was briefly interrupted by a dip in activity in the first half of 2016 as market participants began to digest risk-retention rules mandated under the Dodd-Frank Act that took effect in December 2016. However markets regained momentum in 2017, driven by regulatory clarification of the risk-retention rules. The US CLO market received a further boost at the beginning of February 2018 with a favourable court ruling that effectively exempts CLO managers from credit risk retention rules mandated under the Dodd-Frank Act.
In Europe, the revival of the CLO market began in 2013, albeit from a much smaller base. New CLO issuance grew from EUR 7.8bn in 2013 to EUR 20.9bn in 2017 2 . The growth of the market has been underpinned by multiple dynamics, including an improved investor sentiment and a concerted push by regulators to unlock capital markets as a source of corporate loan growth. Similar to the dynamic seen in the US, the ECB‘s extension of QE towards high-rated corporate debt pushed yields down across the curve, encouraging corporate sector borrowing and investor search for yield.
It is worth noting that the CLO market remains relatively smaller in Europe compared to the US, with EUR 8.1 bn fresh CLO issued in Q4 2017 vs. USD 29bn in the US. The leveraged loan market remains largely driven by Germany, France and the UK, where leveraged loans have grown in line with financial sponsor activity.
Tailwinds to continue
In 2018, the tailwinds underpinning CLO activity in the US are expected to continue, driven by investor demand for CLO notes. However, the entry of new types of investors into the primary leveraged loans markets as “direct lenders” may drive down yields available on the asset side, putting pressure on CLO spreads. In this evolving CLO landscape, CLO investors and managers are partnering with service providers to control costs, streamline portfolio administration and improve productivity while remaining focused on their core activities.
Market participants have partnered with Deutsche Bank’s Trust & Agency Services for the full range of front, middle and back end services for CLOs, SMAs and other complex fund structures. Deutsche Bank has extensive capabilities in the CLO and loan administration services, including providing clients access to the most robust web-based technology available in the market. In addition to trust services, Deutsche Bank offers a range of deal-critical services such as collateral administration and customised deal analytics.
An article by Yousif Mohammed Vice President, Market Development, Trust & Agency Services at Deutsche Bank
1 Bloomberg https://www.bloomberg.com/news/articles/2017-12-21/four-themes-to-watch-in-european-clos-after-groundbreaking-year;
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