CLOs: What will drive issuance in 2020?

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CLOs: What will drive issuance in 2020?

February 2020

The SFVegas 2020 conference from 23-26 February will bring together structured finance industry professionals to discuss the outlook for CLOs. Ahead of the event, Deutsche Bank’s Steve Hessler assesses how general improvements in the global economy and a broadening of collateral types could propel the industry forward

The global collateralised loan obligation (CLO) market eased into the new decade with only five new issuances in the first month. The US market produced only four deals in January 2020, down from seven at the same time last year, while Europe replicated last year’s performance with just one deal1 .

Elucidating the dearth in new issuance, one collateral manager shared that typically they have high single-digit CLO warehouses open at a time. However, so far in 2020, they have “only” four. While four is generally ambitious for most managers, it prompts the question: how many CLOs will be issued in 2020? Within these currently tepid waters, structured finance professionals at the SFVegas conference 23-26 February will consider what could stimulate the issuance outlook for 2020.

Dr Rebecca Harding

Steve Hessler

Director in the Corporate Trust team

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And what is the outlook? Deutsche Bank Research’s 2020 Securitisation Outlook2 projects US$90bn in US new issuance for this year, a 20% decline from 2019, and 29% lower than 2018 (see figure 1 for a year-to-date comparison with 2019 and 2018). Managers are pre-empting a persistent low interest rate environment by delaying full reset, or refinancing all debt tranches. In Europe, the research team forecasts €22bn of new issuance versus €29bn in 2019, but they still expect leverage loan CLOs to dominate new issuance within structured finance (see figure 2 for comparison).

 

Figure 1: US CLO issuance, comparison with 2018, 2019 and 2020 forecasts

Source: Deutsche Bank, S&P LCD 

Figure 2: European securitisation outlook for 2020

Source: Deutsche Bank 

Reviewing market conditions

The signing of a phase one trade deal between the United States and China in January 2020, along with modest improvements in the global economy that sent stock markets to record highs, pave the way for a better year than forecasted. Following three rate cuts in 2019, US interest rates are predicted to remain unchanged throughout 2020. However, the Federal Reserve stands prepared to cut rates further should business falter in conjunction with persistently low inflation levels. Concurrently, the Fed may also let inflation run hotter than its 2% target for some period of time, and so the balance suggests there is a higher bar to raising rates than lowering them.

In Europe, the European Central Bank (ECB) also eased rates further in 2019, setting the course for a benign interest rate environment to continue into 2020. However, on January 23 2020, the ECB launched a “strategic review” to determine if its inflation and other monetary targets remain appropriate. As the ECB’s review is not scheduled to be completed until the end of the year, existing low rates are likely to continue, with potentially even lower rates if conditions warrant them.

The spread of the Novel Coronavirus that originated in Wuhan, China may catalyse a further material reassessment of the economic outlook that any rate changes would require.

If not contained quickly the virus could affect trade not just between the US and China but also between Europe and China. Its impact will be a key determinant of how the markets fare in 2020.

 

Broadening collateral types

Sufficient collateral generation could also improve the arbitrage of asset and liability spreads to make new CLOs work
Steve Hessler

My previous flow article, titled Rethinking CLOs, suggested that a broadening of collateral types could address the dearth of collateral that puts the breaks on CLO formation. Sufficient collateral generation could also improve the arbitrage of asset and liability spreads to make new CLOs work.

A rise in corporate default rates may also impact collateral formation. Deutsche Bank Research forecasts a rise in corporate defaults during 2020 from low 2% to the 3% range in both the US and Europe3 . It also expects corporate rating downgrades to weigh on CLO collateral quality.

In addition, collateral quality tests could also prevent failures for CLOs whose managers made an overly aggressive bet on corporate entities remaining investment grade. In fact, some managers specialise in investing in CCC-rated securities and have outsized buckets for these securities in their CLOs. So long as the investor is comfortable with the terms of the CLO’s collateral quality tests that were negotiated at the outset of the transaction, as well as that managers’ expertise in the asset class, there should not be any undue concern.

The trend towards sustainable investing could trigger a broadening of the CLO asset class beyond the standard broadly-syndicated and middle-market loan CLOs, towards project finance CLOs and those focused on companies that adhere to environmental, social and governance, aka ESG, standards. Finally, the first Applicable Margin Reset auction, a procedure developed to provide an alternative to refinance the interest rate on the outstanding rated classes of CLOs, will be tested in the first quarter of 2020.

 

Conclusion

The signing of the phase one trade deal between the US and China and a persisting low interest rate environment could bode well for the CLO market. Collateral formation could also pave the way for further CLO issuance in 2020.
However, as economist Edgar Fiedler advises: “If you have to forecast, forecast often”, I encourage you to stay tuned for further projections after SFVegas 2020.

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