EM looks very cheap, but patience a virtue
Markets have clearly experienced some periods of volatility this year, and while European CLOs haven’t been immune to this, both fundamentals and prices have been remarkably stable. Another notable development in 2021 has been the emergence of ESG as a more important topic in CLOs, with most deals now having exclusion language in place for so-called sin sectors and the availability of ESG data improving considerably (though there is still some way to go).
At the start of 2021 we expected a modest pick-up in CLO supply compared to the previous two years, and a pick-up in CLO refinancings as some deals started get to their end of their economical life. We got the direction of travel right, but we got the numbers wrong by some margin; new issue volume of €36bn year-to-date (with a month of the year to go) has increased the size of the European CLO market by around 20%, and on top of that we have seen some €58bn of CLOs successfully refinanced, bringing total primary activity YTD to a staggering €94bn.
A number of years ago CLOs were only a tiny part of the wider European ABS market, but today they account for over one third of it. This makes CLOs an asset class that is hard to ignore, but also one that has seen a tremendous improvement in liquidity over the years, with most investment banks now having dedicated traders and dedicated balance sheet for CLOs. This growth has come at a price, however. European ABS investors have struggled to keep up with the pace of growth in 2021 and this has caused periods of indigestion, leaving the market exposed to softer spreads at times. AAA CLO bonds in euros have been priced with yields in a range between 0.78% and 1.06% this year, and though spreads have tightened a little bit since the summer, they still trade closer to the top end of this range at around 1%.
Now 1% might not look like a lot, but let’s not forget that this is a floating rate, AAA rated asset, and despite all the talk of economic recovery, inflation and rising rates we remain in a stubbornly low yield environment. If we compare this to the BAML Euro Non-Financial index, with its 5.9 year duration, BBB+ average rating and just 0.5% of yield, a 1% on AAA European CLOs starts to look very attractive. The obvious question then is why AAA CLOs trade wider than BBB corporates, surely that makes no sense? Clearly there’s something of a perceived complexity premium attached to CLOs, but in our view the real answer is that the European Central Bank doesn’t buy CLOs.
If we look a little lower in the capital structure, BBB and BB notes have also widened by around 50-75bp this year, and like AAAs they are currently trading towards the upper end of their 2021 ranges, which are 300-375bp and 575-650bp respectively. However, at current euro yields of 3.5% and 6.2% respectively, they give investors a very healthy running yield, which offers protection against a certain degree of volatility. And though CLO spreads have widened a little bit this year, from an investor’s point of view the refinancing of older CLOs has allowed for some capital gains, offsetting the widening and making it one of the best performing fixed income asset classes of 2021.
When we consider the credit performance of CLOs’ underlying leverage loans this year, we have seen a large number of upgrades, increased prepayments (since the M&A market has been on fire) and a sub-1% default rate in Europe. Such was the expected economic impact when the pandemic struck in Q1 2020 that we had to develop and run new base and stressed case scenarios for leveraged loans, and at that point we couldn’t have imagined leveraged loans would perform the way they have done in the nearly two years since. CLOs are structured to sustain periods of stress and volatility without impacting bondholders’ payments, and through both the global financial crisis and now the COVID-19 pandemic their performance has demonstrated this resilience.
So where does that leave us for 2022? Given recent M&A activity we think the primary CLO market will be very active again in the first half of the year, and we don’t see a lot of room for BB and B spreads to tighten materially from today’s relatively wide levels (6.2% and 9.2% yields). However, a rising rate environment should result in increased demand for floating rate assets , especially at investment grade level, where CLOs offer a scalable investment opportunity. For the whole of 2022 we do expect increased volatility, so timing and trading will be crucial, but in general we see slightly tighter spreads by the end of 2022 across the capital structure and some solid coupon clipping.
Given our low default outlook for the next 12 months, the continued search for income and their lack of duration, CLOs are one of our top picks for 2022 – we think they offer the best risk-adjusted returns in the floating rate universe.