EUROPEAN CLO MARKET ANALYSIS (Q1 2014) A DETAILED ANALYSIS OF THE EUROPEAN CLO MARKET IN Q1 2014, PROVIDED BY EUROMONEY SEMINARS AND PEARL DIVER CAPITAL
Introduction Written by Tom Preselo, Senior Seminar Manager at Euromoney Seminars 2013 saw the European CLO market reopen with a bang. Deal volumes surged from two deals in 2012 to over 20 issuances. There is market optimism that this year will be even bigger with more deal flow. Q1 saw 7 EUR deals for 3 billion close and March saw the largest issuance volume since the financial crisis. Driving this trend is recognition amongst the central banks and regulators that securitised debt will play a key role on the road to global economic recovery. The CLO market and securitisation has been identified as a critical source of credit to SMEs and midmarket companies in the current credit drought, and continues to be a core funding tool for corporate financing activities and leveraged loan placement. All signs are pointing towards the next stage of the markets development and CLO deal fundamentals look set to remain aligned for 2014. Leveraged loan bankers remain bullish for the year ahead with a brighter outlook for collateral supply and primary loan pricing. Issuers seem to be coping with regulatory pressures, whilst deal arbitrage and economics continue to stack up with CLO spreads showing a trend of tightening further. Appetite remains among the investor community keen to gain access to European corporate credit with attractive relative returns against other asset classes. In the document, Indranil (Neil) Basu, Managing Partner and CEO at Pearl Diver Capital, will provide more in-depth analysis of the market dynamics. He is upbeat about the year ahead, detailing recent activities in the US and European primary and secondary CLO markets.
About Indranil (Neil) Basu Indranil (Neil) Basu has more than 15-years experience in European Securitised Products, ABS & Structured Finance. Prior to founding Pearl Diver Capital, he served in variety of senior roles, most recently as Managing Director and European Head of Structured Products at institutions such as Nomura Securities and Wachovia Securities (now Wells Fargo) in London. He has led a variety of securitisation transactions in asset classes ranging from consumer loans, mortgages, emerging market future flow assets, to sports event receivables, leveraged loans & high yield, ABS, private equity and hedge fund portfolios. He is a graduate in Electronics Engineering from the Indian Institute of Technology (IIT) and holds an MBA from the University of North Carolina, USA. Growth in European loan markets Loan markets in the US in Q1 2014 witnessed a drop in refinancing rates, growth of new issue loan supply and a decline in the rate of inflows into loan retail funds. M&A and LBO activity in the opening quarter hit the highest level since 2007 at $102bn, refinancing fell 14.4% compared to Q1 2013 and re-pricings in March slowed to a four month low. New issue volumes pushed the S&P LCD LLI to a record $710bn as M&A activity increased. Q1 also saw an increase in 2nd lien issuance, up 130% year to date to $8bn with an average yield to maturity of 9.0%. The trend of cov-lite issuance remains high and is likely to continue. Amend to extend activity picked up in Q1 2014 with $22.2bn of volume, up from $11.0bn in Q1 2013. Loan markets in Europe have seen new issue volumes moving higher and this is set to continue with a healthy pipeline of primary loans. In Q1 2014, 13.7bn of primary loans was issued marking an increase from Q4 2013 ( 12.3bn). The pipeline should however ensure that the sequential growth in new issue continues into Q2. There are a further 13 transactions with potentially over 17bn of loans to follow in the next quarter. Leveraged Loan Issuance Volumes CLO markets gather momentum Monthly CLO Issuance Volumes The primary and secondary CLO markets had a very active Q1 2014. After a slow start in January, global CLO issuance picked up speed considerably and reached $ 31 billion over 62 deals (55 US CLOs for $ 26.94 billion and 7 EUR deals for 3.0 billion) in Q1 with March seeing the largest issuance volume since the financial crisis. Current average weekly issuance is around $ 2.65 billion. Regulatory uncertainty around the Volcker Rule and impending effect of Dodd-Frank have contributed to keeping CLO AAA spreads at levels elevated from what many would consider fair value. However, overall, CLO investments, especially in CLO Equity, continued to provide attractive risk adjusted returns far surpassing that of most other asset classes. The benign default environment in the underlying leveraged loans helps provide strong stable cash flows to investors. Currently the most attractive relative value is provided by Equity tranches in 1.0 CLOs along with AAA and Equity tranches of 2.0 CLOs. Going forward the CLO market is expected to gather momentum with a very large proportion of outstanding 1.0 CLOs starting to amortise, offsetting the new issue volume to a large extent, keeping net supply of CLO bonds negative to slightly positive.
Market dynamics in Q1 2014 The following market dynamics observed during Q1 2014 are expected to set the pace for the rest of 2014. Softening in Loan Prices: Since late January when loan prices hit recent highs US S&P LCD Leverage Loan Index (LLI) flow names have declined -100bps from 100.48 to 99.48 and the JP Morgan broader leverage loan market reading declined -36bps from 99.31 to 98.95. In Europe S&P LCD European Leveraged Loan Index (ELLI) flow names remained flat at 100.68 over the same period however the broader S&P ELLI reading declined -40bps from 91.86 to 91.45. Lower retail mutual fund flows, combined with a net negative CLO supply seem to have contributed to this trend and expected to benefit CLOs which are currently ramping or are in their reinvestment period. Still Benign Default Outlook: In Q1 2014 the US 12 month lagging default rate by principal balance of the S&P Leveraged Loan Index fell to an 18 month low of 1.21% falling from 2.11% at FY 2013. By number of issuers the default rate decreased from 1.61% to 1.02% marking a 22 month low. This marks the highest level since July 2013. By percentage of issuers the European default rate increased from 4.90% to 5.30%. CLO New Issue Liability Spreads - US Primary CLO AAA spreads have started to show some tightening trends with most of the deals still being talked about in the L+150bps to L+160 bps range with a few recent ones getting done at L+145 bps. In Europe Primary CLO AAA spreads have been in the E+140 bps to E+150 bps range with some recent deals being done in the E+135 bps. In summary the current arbitrage in new issue CLOs is slightly more in favour of Europe compared to that of the US. This is a function of better spreads in the loan portfolio combined with relatively tighter spreads on CLO liability. Healthy Secondary Volumes - During Q1 2014 the secondary market continued to be very well bid with demand for good quality CLO bonds far surpassing supply with $ 4.65 billion of US CLOs trading on BWICs till date. Regulatory Uncertainty - One of the continuing key themes in the CLO market has been regulatory uncertainty. In particular the market has been looking for clarity around the Volcker rule and how it might impact the AAA investor universe. In their latest update the US Federal Reserve has extended the effective date from which the rule would apply, with regard to bank ownership of CLO tranches, to July 2017. The extension will be applicable to CLOs issued before December 2013. The extension allows banks additional time before they have to comply by amending existing CLOS to remove bond buckets. The Volcker rule might facilitate debt refinancing as some banks may find it easier to exit non-compliant investments through refinancing. Equity investors might also be able to get more concessions in the form of tighter spreads or amendments to the WAL test, from the senior debt investors, in return for agreeing to remove the bond buckets. Prepayments - Another key issue surrounding CLOs, especially in the US, has been the rapid pace of underlying loan prepayments. The faster than usual rate of prepayment has resulted in a faster than expected rate of amortisation in some of the earlier vintage CLOs. In Europe however the rate of prepayments and spread tightening has been significantly lower compared to that of the US.
More from European CLO market events Market presentation: 'Attracting third party equity investors into the game to kick start new CLO issuance 2013 attendee list: European CLO Congress 2013 Share this market analysis