New European CLO investors must chart a steady course

The remainder of the year looks set to be an active one for European CLOs. To sustain growth, the market needs to find new investors, but they have a challenging course to navigate.

Some potential new CLO investors are understandably hesitant, given widely voiced regulatory concerns and related alarmist mainstream press reports about the next financial crisis being driven by a collapse in leveraged loans. Many, though, are looking beyond those stories and recognise that perhaps the same – if not worse – could be said of other sectors.

For example, the high yield and investment grade bond markets are seemingly not being scrutinised for the now-inherent leverage across the board and liquidity supported from external sources, such as ETFs and other retail structures. Should a broader crunch come and drive extensive outflows from such vehicles, there is no obvious source of replacement liquidity – especially now that bankers state, privately at least, they are no longer interested in vanilla bond market-making.

Direct lending has also created its own distractions. It is undoubtedly a sound concept with some highly successful proponents, but there are increasing signs of corners being cut and poor underwriting. Nevertheless, the black box non-mark-to-market nature of such investments has hitherto ensured that even smaller more cautious investors have allocations for direct lending, but have until now shied away from CLOs.

That is not to say all is rosy in CLOs either. Global economies are at the end of the credit cycle and while those with long-enough memories know that doesn’t mean there has to be a crisis, it does mean tougher markets. Not least that it becomes increasingly difficult to time investments.

Equally, the European leveraged loan market is seeing a dispersion in loan quality. Even ramping up new CLOs and therefore only dealing with new loans, which should be at their best, some managers now report that as few as one in two are getting their approval.

New loans are, however, changing hands. Some firms are being forced into a corner by the need to fulfil new issuance quotas, so have no choice but to add sub-optimal loans to their portfolios. While rumours of one manager without the luxury of a long ramp-up period buying a piece of every single loan on the market are perhaps apocryphal, there is no doubt that manager selection and tiering should go beyond lip service and market formality.

For new investors that can navigate beyond the various distractions and find the right structure in the right hands, the benefits are self-evident in yield hungry but risk cautious times. Take one recent real-world example of a new investor able to swap out of a triple-B Peruvian euro-denominated bond holding into similarly rated European CLOs.

Towards the end of August the bond – Peru, 3.75% 1mar2030 – was giving a yield to maturity in the high 50s basis points, while new issue generic triple-B CLO spreads were above 380bp. So the investor’s new position was effectively giving in excess of six times the old spread with no duration risk. At the same time, CLOs offer a Euribor floor that ensures a positive return, while the bond only offered a zero coupon floor.

Mark Pelham