Declining credit enhancements, increased warehouse activity, and the need for stress testing shape the market

CLO investors are grappling with declining credit enhancements and tighter spreads, raising concerns about risk assessment and future returns. Speaking to SCI, market sources highlight challenges for mezzanine and equity investors as attachment points weaken.

Despite these pressures, increased warehouse activity suggests stronger European CLO issuance ahead. SCI’s sources emphasise the importance of stress testing and careful credit selection, while warning that deflation remains an overlooked risk in the current market.

“One issue that concerns investors is the significant decline in credit enhancements over recent years,” according to a senior CLO trader.

“This presents a bigger problem because if you purchase a double-B credit today with a 9% attachment, you would have been buying single-Bs coming out of COVID with a 10% attachment. This raises concerns; we know that these attachments have decreased, and now investors are facing tighter spreads with less favourable bonds,” he explained.

The senior trader noted that this situation is particularly problematic for those investing in mezzanine securities or equity. However, he remains optimistic about equity investments, considering the timeframe for recovering their value.

“Interestingly, purchasing some equity today seems to be less risky than investing in double-Bs due to their current pricing. If I expect to get my money back in about four years, that’s historically not a bad timeframe,” he said.

The senior trader highlighted that in this challenging environment, taking on what may appear to be more risk could actually involve less risk when evaluating cash flow profiles.

Increased warehouse activity signals higher CLO issuance

From a CLO arranger’s perspective, one of the main factors currently affecting the CLO market is the increase in number of warehouses opened this year.

The head of CLO primary at a European bank told SCI: “I believe new issuance volume in Europe will be significantly higher than last year.”

“While we need assets for those warehouses that may have a longer lifespan, our current numbers of incorporated warehouses compared to last year suggest we are much better off. Additionally, as we look at resets, there are certain vintages that are almost forgotten or overlooked, but they're going to be ready to come into play very soon.”

He predicted that this year could resemble the vintages of 2018, 2020, and 2021 when it comes to triple As, which are now in the low 120s in Europe.

Importance of stress testing

Tightening spreads and credit quality are also key drivers in the CLO market, while portfolio stress testing has become an essential tool for managers to measure resilience, enhance performance, and adapt to changing conditions.

The senior trader goes on to explain that stress testing can be approached in two ways: by evaluating yields or through fundamental analysis.

“When deciding which bonds to buy, my choice could depend on either the bond's yield or its quality. We run stress tests on all options to see if the results align with expectations. Sometimes, bonds can act like different types. For example, you might encounter a double-B rated bond that behaves more like a single-B rated bond, lacking the expected characteristics,” he said.

The fundamental analysis approach may lead to the decision not to purchase any bonds at all and instead keep funds in cash, returning them to investors. In this scenario, fundamental analysis helps determine whether it's the right time to invest.

“Over the last 20 years, we've experienced zero interest rates. Back in the 1980s and 1990s, the default rate hovered around 5%. It's somewhat surprising that we haven't seen more defaults, though they may be on the horizon,” the senior trader added.

Deflation: An underestimated risk?

On potential risks in the CLO sector, SCI was told that deflation risks are often underestimated.

"One aspect that isn’t often considered but poses a potential downside risk is deflation. We have observed deflation in China, and while it isn’t widely expected in the US, there are valid reasons for this outlook,” the senior trader explained.

“The US has productivity growth, whereas the UK and Europe do not. Therefore, we cannot completely rule out the possibility of deflation in some G7 economies, which could certainly pose a risk for investors."

Regarding potential improvements in the European CLO market, the senior trader emphasised the importance of timing when buying credit, especially in CLOs where the majority of holdings are in leveraged loans.

"If you buy at the wrong moment, you risk losing money. It is crucial to know what to buy and when to buy it. At this stage in the economic cycle, merely being invested is not sufficient; you must be aware of potential pitfalls. Prices have risen significantly, and spreads have tightened, leading to a shift in how risk is assessed today compared to three years ago. Consequently, it is essential to approach the market with caution at this time,” he concluded.

Camilla Vitanza