It’s been a busy and promising start to the year for much of the European ABS market, with two Dutch and two UK RMBS deals printed along with a French CMBS.
By contrast, European CLOs have been slower off the block, probably because of the comparative length of their marketing process. Typically the placing of the equity takes priority, and only once that is done will the investment bank leading the transaction look to start placing the AAA notes before finally marketing the whole capital structure publicly. We have started engaging with some of the banks on the first deals of 2020, some of which should be priced at the start of this week.
Our long-term readers will know we have been advocating the potential benefits of CLOs for a while. We have cited strong credit performance, the relative spread opportunity compared to other fixed income sectors, the value of the Euribor floor and diversification as some of the factors we believe have presented material upside for investors.
Given the material positive performance seen in other parts of the fixed income markets in 2019, the CLO relative value proposition now looks even more attractive. Most financial markets had a bad end to 2018 as the US-China trade war, Fed policy and Brexit all hit sentiment, meaning 2019 opened at cheap levels, allowing for a strong year. This wasn’t the case in CLOs, however. The European High Yield Index Crossover, for example, tightened from an opening spread of 373.5bp to 207.5bp over the course of 2019, while comparable BB CLO spreads could only manage a single-digit move from 670bp to 662.5bp, trading in a range of 110bp.
Why the difference?
Firstly, CLOs are undoubtedly more complex than a typical corporate bond. Investors need to do due diligence on the CLO manager, there is a significant amount of documentation to get through, and that’s before they have even started their cashflow and credit modelling. This means the investor base is smaller (though it is growing), and so the market is typically less correlated to swings in other markets, as less capital tends to move from a buoyant European high yield market to a cheaper CLO market.
In addition, the CLO market has its own technical balance of demand and supply to manage. This is a part of the ABS market that was slower to restart post-crisis, with new issues appearing in 2013 and steady growth from 2014 to 2017 (per annum volumes grew over that period from €14bn to €20bn). However, the last two years have seen €28bn and €29bn of issuance respectively, including eight new CLO managers in 2019 taking the universe to 57. In our view this supply has undoubtedly helped keep spreads wider in the face of strength in other financial markets.
The US investor base has also impacted the technical in euro CLOs. The US leveraged loan market saw significant outflows in 2019, covering 51 of the 52 weeks in the year, with a knock-on impact to pricing in US CLOs (for which leveraged loans provide the raw material). As US investors saw better relative value in their domestic market, shifts were often funded by selling holdings in European CLOs, further pushing pricing around.
Looking forward, while we expect a few new managers to enter the European market in 2020, this trend should slow. The widening of CLO spreads in late 2018 made the arbitrage for CLO equity holders more challenging in 2019, as did the lack of leveraged buyouts, which reduced the supply of new loan investment opportunities and kept the yield on the asset side of CLO arbitrage low. These factors together should contribute to a more manageable supply of new issue European CLOs in 2020.
Given this anticipated slowing in supply, we could see a reversal of the technical imbalance that has held CLO spreads at what we consider to be truly cheap levels in recent months. If an investor has the capacity and experience to do the requisite analytical work, this is one of the few sectors in global fixed income where we continue to see compelling value on an absolute basis, not just a relative one.