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CLO Interest Summary - December 2017

Core Content

This document provides a comprehensive outlook for the U.S. and European CLO markets in 2018, analyzing the impact of macroeconomic conditions, structural changes, and collateral quality on CLO performance and issuance. It outlines key trends in loan underwriting, regulatory environment, and investor behavior, along with the implications for credit risk and CLO rating methodologies.

Main Points

U.S. CLO Outlook

• Economic Growth and Liquidity: Continued economic growth and solid liquidity are expected to support stable CLO performance in 2018, even as collateral quality deteriorates.
• Collateral Quality Deterioration:
  • Collateral quality is expected to weaken due to increased lending to SMEs and higher leverage.
  • The average LGD for CLO collateral rose to 38.0% in Q3 2017 from 35.7% in Q3 2016.
  • B3 obligors accounted for 39% of leveraged loan issuance by issuer count, the highest since 2014.
• Structural Changes:
  • CLO 2.0 structures will remain largely unchanged but may allow for more flexibility in amendments, potentially increasing credit risk.
  • CLOs may trade off collateral quality parameters to ease pressure on WAS and WARF tests, but this could lead to more test breaches.
  • The average WAS for CLOs declined to 4.1% in September 2017 from 4.8% in September 2016.
• Default Rates:
  • The speculative-grade default rate is expected to decline to 2.1% by October 2018 from 3.2% in October 2017.
  • Moody's Liquidity-Stress Indicator (LSI) fell to 3.0% in Q3 2017, indicating improved liquidity.
• Issuance Trends:
  • CLO issuance in 2018 is expected to remain high, similar to 2017's level of around 180 deals totaling $100 billion.
  • Refinancing activity will slow, while resets will make up a larger portion of new CLO ratings.
  • The Crescent Letter allows for refinancing without full compliance with risk-retention rules, but not multiple refinancings of the same tranche.

European CLO Outlook

• Macro Stability: European CLOs are expected to maintain strong credit quality and performance due to stable macroeconomic conditions.
• Collateral Quality:
  • Collateral quality is expected to remain stable, with slight improvements due to tighter underwriting standards.
  • The average WAS for European CLOs declined to 4.1% in September 2017, but few CLOs are expected to fail these tests.
• Structural Features:
  • CLO 2.0 structures will remain largely unchanged, but with some flexibility in collateral quality tests.
  • The weighted average subordination level for Aaa (sf) CLOs is expected to remain around 40%.
  • The weighted average life (WAL) of CLOs is expected to increase due to longer loan maturities.
• Default Rates:
  • The European speculative-grade default rate is expected to fall to 1.1% by Q4 2018 from 2.1% at the end of 2017.
• Sector Exposure:
  • The top 10 sectors in European CLO 2.0s are mostly stable or positive, with minimal exposure to the most troubled sectors.
  • The EMEA Liquidity-Stress Indicator (LSI) improved to 8.1% in October 2017, its best level ever.
• GDP Growth:
  • European GDP is expected to grow at 2.2% in 2017 and 2.0% in 2018, supported by home price growth and falling unemployment.

Key Information

• CLO Issuance:
  • U.S. CLO issuance in 2018 is expected to match 2017's level of around $100 billion.
  • European CLO issuance is expected to be similar to 2017 levels, despite expected collateral scarcity.
• Collateral Quality Metrics:
  • In the U.S., CLO collateral quality metrics will continue to worsen, with some CLOs failing tests.
  • In Europe, collateral quality is expected to remain stable, with slight improvements due to tighter underwriting.
• Structural Flexibility:
  • CLO 2.0 structures are expected to allow for more flexibility in amendments, which could increase noteholder risk.
  • Managers may seek to increase WAS by including lower quality or higher-yielding collateral.
• Regulatory Environment:
  • The Crescent Letter allows for refinancing without full risk-retention compliance, but not multiple refinancings.
  • Regulatory guidance on leverage remains in place, though its impact is limited by aggressive EBITDA projections and nonbank lending.

Summary of Trends

• U.S. Market:
  • Collateral quality will deteriorate, but CLO 2.0 structures will help mitigate risk.
  • Default rates are expected to decline, supported by economic growth and liquidity.
  • Issuance will remain high, with resets becoming more common than refinancings.
• European Market:
  • Collateral quality is expected to remain stable, with some improvements due to tighter underwriting.
  • Default rates are expected to fall, driven by macro stability and improved liquidity.
  • Structural changes are limited, but flexibility in amendments could increase noteholder risk.

Key Figures

• U.S. CLOs: 889 rated CLOs with total par of $432.1 billion.
• European CLOs: 197 rated CLOs with total par of €65.2 billion.
• Default Rates:
  • U.S. default rate: Expected to decline to 2.1% by October 2018.
  • European default rate: Expected to fall to 1.1% by Q4 2018.
• WAS:
  • U.S. WAS declined to 4.1% in September 2017.
  • European WAS also declined to 4.1% in September 2017.
• LGD:
  • U.S. average LGD for CLO collateral rose to 38.0% in Q3 2017.
• LSI:
  • U.S. LSI dropped to 3.0% in Q3 2017.
  • European LSI improved to 8.1% in October 2017.

Conclusion

Both the U.S. and European CLO markets are expected to remain stable in 2018, supported by economic growth and liquidity. However, the U.S. market faces greater challenges due to weakening collateral quality and structural changes, while the European market benefits from tighter underwriting and stable macroeconomic conditions. CLO 2.0 structures will continue to play a key role in managing credit risk, though increased flexibility may introduce new risks for noteholders.