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CLO Interest Summary

Core Content

This document provides a comprehensive analysis of the CLO (Collateralized Loan Obligations) market in the US and Europe, focusing on regulatory changes, market trends, and credit implications. It includes insights from Moody's CLO/Structured Credit Group and market participants, particularly from the True Sale International conference.

Main Points

CLOs - US: Elimination of Risk-Retention Rules

• Regulatory Change: The US Court of Appeals ruled on February 9, 2018, that open-market CLO managers are not required to retain credit risk under the Dodd-Frank Act.
• Credit Neutrality: The elimination of risk-retention rules is considered credit neutral for CLOs, as existing structural mechanisms already align the interests of managers and investors.
• Indirect Credit Effects: The ruling may lead to more CLO managers entering the market, increasing competition for leveraged loans. This could either worsen underwriting standards (credit negative) or improve refinancing access and reduce default risk (credit positive).
• Refinancing Impact: CLO refinancings will likely increase, which is a credit positive as it lowers the cost of capital and offsets the negative effects of loan re-pricing.

Structured Finance - US: Securitization as a Funding Source

• Securitization Growth: Securitization has grown as a funding source for the US economy, though repayments have outpaced new issuance in most asset classes.
• Government Dominance: Government-backed or -guaranteed debt continues to dominate in housing and higher education, while private-label securitization is more prevalent in leveraged loans and auto loans.
• Private-Label Decline: The share of private-label securitized funding in major asset classes fell to 11% in 2017, the lowest since 2007. Including government-backed debt, it dropped to 48% from 55% in 2009.
• CLOs and Auto Loans: CLOs, auto ABS, and commercial ABS have seen increased securitization, while residential RMBS and student loan ABS have seen declines.
• Global Comparison: Securitization funds a larger share of US household debt (55%) than in Europe (18%), where covered bonds are more common.

CLOs - US: Sector Update - Q4 2017

• Market Stability: Macro volatility indicators remained stable, with slight improvements in the Financial Stress Index and low VIX levels.
• Leveraged Loan Activity: Refinancing activity increased, contributing to higher issuance volumes and tighter spreads.
• CLO Issuance: CLO issuance volume reached near-record levels in 2017, with 95.7 billion in new issuance and 48.7 billion from resets.
• Credit Quality: CLO asset credit quality metrics were mixed, with declining loan recovery rates and increasing exposure to lower-rated assets.
• Upgrades vs. Downgrades: Deleveraging of amortizing CLOs led to a significant number of upgrades, while a few downgrades were attributed to collateral deterioration and market risk.

CLOs - Europe: Sector Update - Q4 2017

• Strong Issuance: European broadly syndicated loan (BSL) CLO issuance remained strong, with 12.1 billion in par value for Q4 2017.
• Credit Quality Deterioration: Credit quality of existing CLOs worsened, with significant drops in WARF and increased exposure to Caa-rated assets.
• Cov-lite Loans: Cov-lite loans have become the de facto standard, though their non-standardized definitions complicate comparison and monitoring.
• Expected Default Rates: The speculative-grade default rate for European non-financial corporates is expected to decline to 1.2% by the end of 2018.
• Refinancing and Resets: Refinancing and reset activity have helped prevent the emergence of "zombie CLOs" by maintaining flexibility and reducing credit risk exposure.

CLOs - Europe: True Sale International Conference Insights

• Investor Concerns: Investors remain concerned about tail risks in leveraged finance, especially with rising leverage ratios and cov-lite loans.
• Relative Value: European CLOs are still viewed as offering relative value, despite some market challenges.
• Spreads and Valuation: CLO spreads are expected to tighten further, but not return to pre-crisis levels due to higher capital requirements.
• Manager Influence: CLO managers are increasingly flexible, with some deviating from the CLO 2.0 structure, though changes are typically minor.
• Transparency and Trading: Transparency and active trading have become the norm, with specialized data providers facilitating performance and style analysis.
• Future Outlook: CLO issuance is expected to remain around 2017 levels, with potential increases if collateral availability improves.

Key Information

• Regulatory Impact: The US Court of Appeals ruling on February 9, 2018, removed risk-retention requirements for open-market CLOs, potentially increasing market participation and competition.
• Credit Implications: While the ruling is credit neutral, it may lead to mixed credit effects, including both increased competition and refinancing opportunities.
• Market Trends:
  • CLO issuance and refinancing activity have surged in both the US and Europe.
  • Cov-lite loans have become standard, though they pose challenges in terms of comparability and risk monitoring.
• Government Role: The US government continues to be a major player in housing and higher education securitization, while private-label securitization is more prominent in leveraged loans and auto loans.
• European CLOs:
  • European CLOs have seen deterioration in credit quality, with increased exposure to lower-rated assets and reduced over-collateralization ratios.
  • Refinancing and resets are considered "self-healing mechanisms" that help maintain portfolio flexibility and reduce credit risk.

Conclusion

The CLO market in the US and Europe is experiencing significant changes due to regulatory shifts and evolving market dynamics. While the elimination of risk-retention rules in the US is credit neutral, it may lead to indirect credit effects. In Europe, CLO issuance remains robust, but credit quality has declined, particularly in recent-vintage deals. The market is increasingly influenced by cov-lite loans, and refinancing and reset activity are critical in maintaining portfolio health and reducing credit risk. Overall, the CLO market continues to be an important part of the structured finance landscape, with a growing number of participants and a shift towards more active and transparent management practices.