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CLO Interest Summary

Core Content

This document provides a comprehensive outlook for the Collateralized Loan Obligations (CLOs) market in the U.S. and Europe for 2018, focusing on the performance, structural changes, and credit quality of CLOs. It also includes performance updates and analysis of key factors affecting the market.

Main Points

U.S. CLO Outlook

• Economic Growth and Liquidity: Continued economic growth and solid liquidity will support CLO performance in 2018, despite deteriorating collateral quality.
• Collateral Quality Deterioration: Collateral credit quality will worsen due to increased lending to SMEs and high leverage, leading to lower debt cushions.
• CLO 2.0 Structure: The CLO 2.0 structure will mitigate some of the negative impacts of declining collateral quality, but structural weakening is expected due to increased flexibility.
• Default Rates: The speculative-grade default rate is projected to decline to 2.1% by October 2018 from 3.2% in October 2017.
• Liquidity-Stress Indicator (LSI): The LSI fell to 3.0% in Q3 2017, indicating improved liquidity conditions for speculative-grade borrowers.
• Refinancing and Resets: CLO issuance will remain high in 2018, with resets playing a larger role than refinancings due to tighter liability spreads.
• Structural Modifications: Managers will seek more flexibility in CLO structures, which may increase credit risk for noteholders.
• Collateral Quality Tests: CLOs will face tighter margins in passing collateral quality tests, potentially leading to more test breaches.

European CLO Outlook

• Collateral Quality Stability: European CLOs will maintain stable collateral quality due to slow but steady economic growth and low default rates.
• CLO 2.0 Structure: The structure of CLOs will remain largely unchanged, with similar credit enhancement levels and risk-retention mechanisms.
• Monetary Policy: Tight monetary policy in Europe will keep growth in check and support low default rates.
• Default Rates: The European speculative-grade default rate is expected to fall from 2.1% in 2017 to 1.1% by Q4 2018.
• Liquidity-Stress Indicator (LSI): The EMEA LSI improved to 8.1% in October 2017, indicating stronger liquidity conditions.
• Sector Outlooks: Most sectors exposed to European CLOs have stable or positive outlooks, with some, like healthcare and construction, showing improvement.
• Risk-Retention Rules: Managers are likely to continue using the originator route for risk-retention compliance, influenced by Brexit-related changes.

Key Information

• CLO Issuance: U.S. CLO issuance in 2018 is expected to be around 180 deals totaling $100 billion.
• Total Par Value: As of November 2017, Moody's rates 889 U.S. CLOs with a total par value of $432.1 billion.
• CLO 1.0 and CLO 2.0: 39 CLO 1.0s with $7.2 billion in total par and 850 CLO 2.0s with $424.9 billion in total par.
• European CLOs: Moody's rates 197 European CLOs with a total par value of €65.2 billion.
• CLO 2.0s in Europe: 153 CLO 2.0s with €61.5 billion in total par.
• Collateral Quality Metrics: The weighted average spread (WAS) for U.S. CLOs has declined to 4.1% in September 2017, with a significant drop in WAS cushions.
• LGD Increase: The average loss-given default (LGD) for CLO collateral has increased from 35.7% in Q3 2016 to 38.0% in Q3 2017.
• Regulatory Impact: The Crescent Letter allows pre-2014 CLOs to refinance without full risk-retention compliance, but future CLOs may require more input from noteholders for amendments.
• Structural Changes: Managers are incorporating more modifiers to collateral quality tests, which may increase noteholder risk.
• Market Trends: Increased loan supply and a diversifying investor base are expected to support new CLO formation in 2018.

Summary of Key Factors

• Economic Growth: Moderate economic growth and stable liquidity will support CLO performance.
• Collateral Quality: Deterioration in collateral quality due to increased SME lending and high leverage.
• Structural Flexibility: Managers will seek more flexibility in CLO structures, which could increase noteholder risk.
• Default Rates: Expected to decline in both U.S. and European markets due to strong economic conditions.
• Regulatory Environment: The Crescent Letter allows for refinancing without full risk-retention compliance, but future CLOs may be more regulated.
• Investor Base: A diversifying investor base will help lower liability spreads and encourage new CLO issuance.

Outlook

• U.S. CLOs: Performance will remain stable, but collateral quality metrics will continue to worsen, leading to more test breaches.
• European CLOs: Collateral quality and performance will remain stable, with a focus on maintaining credit enhancement levels and risk-retention mechanisms.

Conclusion

The U.S. and European CLO markets are expected to remain stable in 2018, driven by continued economic growth and solid liquidity. However, the deterioration in collateral quality and structural changes will pose challenges, particularly for noteholders. The regulatory environment and investor behavior will play a significant role in shaping the future of CLOs.