European CLO, loan markets discussed

Representatives from Thomson Reuters, Credit Suisse, CVC Capital Partners and Goldman Sachs discussed the European CLO and loan markets in a live webinar hosted by SCI earlier this month (view the webinar here). Topics included primary CLO issuance, loan market developments and the impact of developments in Greece.

Q: How has the European primary CLO market fared?
A: Alex Lembcke, senior market analyst, Thomson Reuters: The European CLO market essentially shut down after the global financial crisis but reopened in 2013. Once it did reopen, issuance increased steadily until mid-2014, when it levelled off. Since then it has averaged above €1bn per month, with three or four new CLOs priced each month.

Most of the CLO market participants I talk to expect around €15bn-€20bn of issuance this year, which would put us at roughly half the issuance we saw in 2006 and 2007, which was €30bn-€35bn of issuance. But still, following the financial crisis, this is very good issuance.

However, CLO aggregate principal balance has decreased as CLO 1.0 deals have wound down. It is now climbing a little but not much, so for the CLO market to grow, issuance will have to be closer to €2bn per month.

Michael Malek, director, Credit Suisse: Despite uncertainty, the market had a strong second quarter, with €4.5bn of new issuance. By way of comparison, there was €4.4bn in 2Q14, although before the crisis there was €10bn in 2Q07.

The CLO issuer market is diversifying away from the larger, more established managers that dominated the early 2.0 issuance. Seven managers priced debut 2.0 transactions this year in Europe and we could see more in 2H15. We can also add that we see more US CLOs being structured to be European risk retention-compliant and this is something which has expanded quite considerably.

Q: What developments have there been in the loan market?
A: Lembcke: There is a large pipeline growing of LBOs, which were put on hold while the Greek situation played out. Leveraged loan issuance has been alright, although demand remains high, so margins are reflecting the fact that it really is a seller's market right now.

If you look at the average margins for term loan Bs and term loan Cs - which is what CLOs generally invest in - this year they started at around 500bp and now are down to about 400bp, so pricing has tightened here. It is still above what it was before the crisis, when levels were around 300bp, but it is down from the start of the year and some people are attributing this to ECB QE and investors chasing yield.

There is a lot of demand for loans at the moment, especially leveraged loans, because of the margin. At 400bp with a 1% Libor floor, you are looking at 5% and that is pretty good in this market.

All of these trends have been reflected in the secondary loan market as well. Yields have come down and bottomed out at around the same area - 400bp. The secondary market is much quicker to react to recent events than the primary market, so in the secondary market you have actually seen yields jump up in the last month from 400bp to 450bp, reflecting some of the recent issues we have been seeing with China and Greece.

Dominic Ashcroft, md, Goldman Sachs: The loan market has been recovering for the last 18-24 months. It was broken after the crisis and significant refinancing was going to the bond market, but while the bond market has grown a lot over the last four or five years, the loan market has now started to come back into favour.

Loan demand comes from CLOs - including US managers as well as European ones - and also from managed accounts and alternative asset managers. When we are looking at a new LBO or are underwriting a piece of capital, we are much more balanced between the loan and the bond product than we may have been a couple of years ago, when loan market demand was less dynamic.

Through the last couple of months we have seen some volatility return to the secondary market, although we still see the European loan market being very well technically bid. If you think about the relative value that we have seen from the trading levels we have observed in the market, the European loan market has not really changed or moved substantially, particularly in the last month, versus some of the movements we have been seeing on the bond side of the market.

Greece has stolen the headlines, but we remain bullish on the technical bid from the loan market going forward. That is going to drive the way banks think about underwriting new commitments that will bring more supply to the loan market over the next six to 12 months.

Q: How has CLO collateral changed?
A: Malek: CLO portfolio construction is broadly as it was and generally changes have been limited. There has been a slight increase in cov-lite allowance from a typical maximum last year of 20% to 30%-35% now. There are also more multi-currency structures, allowing some liabilities to be issued in sterling notes.

That allows the manager to have a bucket for sterling assets without entering into asset swaps, so that gives more flexibility to the manager and allows the manager to increase diversity in the portfolio. We expect to see this feature more in 2H15.

Q: How challenging has portfolio ramp-up been?
A: Jonathan Bowers, senior portfolio manager, CVC Credit Partners: Primary loan issuance this year has been patchy. While January, March and June were strong, we had some fairly slow months in between, and that has made it challenging to put together quality portfolios.

The secondary leveraged loan market is very well bid, particularly in Europe where the market is much more finely balanced than the US. There was a spate of repricings in the second half of May and first half of June, the last three of which received significant pushback and were subsequently dropped.

Large primary deals are pricing a little wide or having structural changes made, partly due to volatile bond flows in the US. This, in turn, brings loan and bond pricing more into line, meaning that when there is no competing bond bid - or the bond bid is wide - loan pricing will move up quite rapidly.

We witnessed that in the second half of last year, when the primary market declined almost 100bp in the first half of the year, clawing it all back in the second half. I do not think we will see that to the same extent this year.

While we believe certain M&A transactions are on hold, we expect more deals to be launched into the market in September, when hopefully macro issues such as the Greek crisis have been put to bed. I think we will see some more interesting deals coming through in the remainder of the year.

In addition, for deals above a certain size, typically about €1.5bn, you really need to go to the US market or capital markets for financing, where we are now starting to see some of the larger buyouts come through again. I think that also makes primary pricing a bit more interesting.

My view is that we will see pricing move up. The main challenge is getting consistent, quality deal flow through. So far, we have seen some fairly patchy issuance in terms of credit quality, interspersed with some stellar credits which are suitable for CLOs.

Q: Where are liability spreads and how does the arbitrage look?
A: Malek: Spreads across the capital structure have tightened since the end of 2014. This is particularly the case at the bottom of the capital structure. Triple-A, double-A and single-A have generally been stable in the regions of 130bp, 200bp and high-200s respectively. Triple-B has tightened a little from the low-400s to mid-350s and double-B from mid-600s to low-500s. Single-B has tightened from mid-800s to high-600s.

Considering Greek events, it is hard to say where a transaction would price today. Despite high volatility, we have seen good resiliency in ABS trading where we have seen some more opportunistic bids, but the offer moved very little.

We would expect the top part of the capital structure to be relatively stable. There could be a little widening at triple-A. Widening could be more pronounced at the bottom of the capital structure.

It is also interesting to note that the US market typically has spread tiering between managers, with triple-A at 140bp for established managers and 15bp-20bp wider for first-time issuers. In Europe this gap is only 5bp-10bp.

Bowers: The interesting interplay is that there is a very large senior secured bond market pricing against a senior secured leveraged loan market and any volatility in the bond market - whether it is a taper tantrum, Greece, Chinese growth concerns - will have an impact on primary pricing. That, in turn, puts the onus on the leveraged loan market to pick up the slack.

Although there has been spread compression on the asset side with repricings, particularly in 2Q15, I think some of that will reverse itself over the course of this year. Additionally, CLOs now have the ability to invest in bond capital - whether it is an FRN format or fixed rate - giving them the opportunity to increase spread on the asset side, both from an absolute basis and from a yield perspective.

That is a real advantage and should bolster the arbitrage opportunity as rates start to edge up and the yield curve enables some floating rate product on the bond side.

Q: What are the implications of the Greek situation for Europe's CLO market?
A: Ashcroft: In the near term Greece has curtailed primary issuance, especially in the bond market, and scaled back the issuance we have been seeing on the loan side of the market.

Somewhat surprisingly, Greece has actually had a more modest impact on secondary trading levels - both on the loan side, which is not too surprising, but also on the bond side - so we have generally seen bond pricing move down a point and a half or two points over the end of June and start of July, albeit with some inter-week volatility. The overall movement has really been following the direction of equity markets.

Equities are back up 2%-2.5% and we have seen the iTraxx move in again to the level that we saw before the Greek referendum. So from that perspective, while Greece has driven a lot of the headlines, it has not had such an adverse effect on the secondary market as we might have anticipated, perhaps because the market has factored in the likely outcomes in advance.

Looking forward to the rest of the summer and into September, there have not been as many outflows as people anticipated, so the net effect - given we have not seen many primary market deals come through - is that people are sitting on a little more cash than they were four or six weeks ago and therefore our view is that if we do get some stability coming back into the market, then primary issuance could start to step up pretty meaningfully, if not in July then certainly when market participants are back from the beach in September.

JL