In two recent blogs – here and here – we talked about the positive technical that we see driving both the CLO and ABS markets in Europe, and the strong relative value we believe current spreads are showing.
For CLOs, while on one side dwindling supply has helped spreads retrace tighter in recent weeks, on the other improving performance has played a key role in bringing investor demand up. With summer now officially over, we wanted to look back at the past six months and review European CLO and loan performance.
The period of volatility experienced in March was unprecedented, and at the time with major economies facing sharp contractions, investment banks and rating agencies didn’t waste any time in darkening their forecasts for corporate credit. High yield default rate projections jumped to reach 7-8% by 2021 (from a consensus forecast of 2.6% in January), and many analysts saw CLO exposure to CCC loans rising from 2% to peak at 15-20% over the course of this year. At the same time, the price of the European Leveraged Loan Index tumbled from 98 to 80 in a two-week period as investors scrambled for liquidity and credit concerns mounted. Higher leverage and lower interest coverage also triggered a wave of downgrades, with nearly a third of the European loan market being impacted.
If the volatility brought on by the COVID-19 outbreak was unprecedented, so too was the reaction of central banks and governments. The fiscal stimulus and the liquidity provided by relationship banks allowed companies to fully draw their revolvers and to weather the storm relatively well. Loan downgrades have stabilised since June and ratings performance for CLO tranches has also surprised to the upside. In general, so far, more ‘watch negative’ resolutions have resulted in affirmations rather than downgrades, with only about 3% of all outstanding European CLO tranches being affected. Most of these downgrades were on sub-IG notes and limited to one notch, keeping them within the same broad rating category. Currently the average CCC bucket across European deals is 7.1% (having decreased from 7.7% in July), far below the 15-20% consensus. The prices of loans in CLOs have generally continued to rally and as of the end of August, roughly 4% of assets in European CLO pools were trading below 80, down from around 18% in April. This current distress ratio gives a forecast for default rates far lower than that predicted in March; in fact CLO pools are seeing a default rate of under 1%, compared to 2% in the leverage loan market.
It is worth highlighting that CLOs are actively managed vehicles, and managers’ actions over the past six months have played a key role in the overall performance of many deals. Despite the high dispersion in metrics across different deals, overall most managers, aided by the rally in the loan market, were able to de-risk in Q2 by rotating out of lower-rated names into higher quality loans, improving their portfolios and curing potential test triggers. We believe it is thanks to credit selection, active monitoring and trading that CLO pools generally are outperforming the broader loan universe in terms of defaults, CCC exposure and distressed assets, and no outstanding European CLO has experienced any interest deferral or losses thus far.
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. How might CLOs perform under this scenario? Stay tuned for more insights in our next blog.