CLOs

Based on these metrics, the picture seems rosy, and credit performance looks set to continue through the second half of the year should the main drivers of the recovery remain intact.

2021 looks set to become a post-financial crisis record year for European CLO issuance and refinancings, but amid the rush of activity we are seeing a concerning trend for weaker documentation in refinanced deals that in our view investors need to fight against.

I think it’s likely we’ll see new cycle tights for the European CLO sector this year, so in addition to healthy income we believe there is plenty of room for capital appreciation as prices are being pushed higher in the secondary market.

Our analysis indicates European ABS investors can carry forward little concern about nasty default surprises, and this is likely to be important when considering total returns for 2021.

Overall CLO and loan performance have exceeded our expectations, though there are still plenty of headwinds for the market, chief among which is the prospect of further lockdowns and more economic disruption as Europe battles a second wave of COVID-19 cases.

There are still plenty of potential bumps in the road (Brexit, the US election, COVID-19 developments and so on) but the positive technical created by dwindling supply has the potential to push spreads tighter in coming months.

We expect September to be relatively busy with new ABS deals, but there’s a very strong technical developing in favour of ABS and CLOs, which should help performance in the coming months.

If floating vs. fixed is no longer the most pressing question, then investors should be more focused on where they get the best credit spread.

In the past few weeks CLOs have become the focus of much attention, both from market participants and the media, especially following the negative rating actions that agencies have taken on the underlying loans as well as CLO tranches.

After six weeks of no supply, the market somewhat surprisingly reopened with three new issue CLOs being priced last week and a new one already on the way. We are aware of many loan warehouses that need to be cleared, and bankers (or rather their risk managers) are no doubt keen for CLO managers to refinance leveraged loans into a CLO.

In the last two weeks we’ve looked at how CLOs behaved during the global financial crisis, and we’ve stress tested a current CLO with GFC-like defaults to see where individual tranches would start to take a loss in that scenario. Keeping in mind the rule that the third in any trilogy is usually either the best or the worst, let’s hope this third instalment is more Toy Story 3 than Tokyo Drift.

Clearly this shock/stress test is a severe scenario, but given the uncertainties that COVID-19 has thrown our way, as debt investors we would rather be overly conservative.