Active management, structural protections and refinancing have aided the resilience of collateralised loan obligations amid a challenging period for structured finance. The increasing embrace of environmental, social and governance factors in CLOs could aid the market's recovery and future growth, says Ocorian's Nick Bland, Head of UK Client Services, and Kareem Robinson, Client Director.*
While there are concerns a Covid-induced corporate distress cycle may feed through into the CLO market, we see very few signs of rising levels of distress so far.
In fact, loan default rates, as defined in CLO documentation, are at this time trending lower than the broader market. In the main, this is due to these vehicles being actively managed and offering structural protections which allow managers to proactively assess the indicators of distress levels and react to them accordingly.
Managers are expected to anticipate signs of stress and trade those out, while also hedging exposure. Indeed, since the global financial crisis, bond buckets, which provide broader credit exposure, and larger CCC and cov-lite buckets indicating a higher risk appetite, have re-emerged in CLOs without there being any material effect of default rates and broader stress indicators.
It is for these reasons there is more resiliency in the CLO markets than some expected to see. Amongst many indicators, this is shown by the weighted average default rating trend, which according to recent research by Deutsche Bank, rose to a peak during the worst of the pandemic but has largely fallen back to normal levels. Weighted average spreads have followed the same trajectory, and over-collateralisation tests have sprung back to levels last seen in January 2020.
However, as the significant policy response to the pandemic begins to be withdrawn, we should expect to see financial weakness among companies emerging, potentially leading to a rise in defaults and distress.
Ahead of any acute distress, what we have seen is a willingness among managers and issuers to work together to restructure, refinance, and renegotiate to avoid hard triggers being breached, ending up in full-blown default restructuring scenarios.
The priority of CLO managers in the past three months has been to take advantage of locking in cheaper financing, particularly in the US, where Ocorian has worked on more than 200 CLO refinancings, sometimes closing two or three a day.
In the European market, there has been a sudden rush of new issuance in the latter half of April and first half of May as demand resumes against the backdrop of society and economies opening up. There have also been some interesting innovations come to the fore in new transactions, such as the reintroduction of bond buckets, issuance of notes in loan format and LIBOR caps, as well as in the area of ESG.
ESG CLOs on the rise
Some CLO managers have in recent years structured transactions that exclude certain carbon intensive industries from their portfolios, for example in the US, Neuberger Berman issued a novel
CLO this year that measures how the assets comply with the United Nations' Sustainable Development Goals.
Such innovations are important for the growth and development of this area of the market, which is seeing rising demand among issuers and investors.
However, there are challenges, such as the visibility around and ability to extract good ESG data which is often buried in multiple places, and the comparability of data sets due mainly to a lack of standardisation in taxonomies.
Regulators are seeking to address these challenges, and the European Union's Sustainable Finance Directive Regulation (SFDR), for instance, should help bring about standardisation in ESG data so that it can be critically assessed. Asset managers operating in the fund space already have transparency obligations with regard to qualitative ESG metrics, and the recent iteration of SFDR launched in March 2021 seeks to promote more standardisation around quantitative - and therefore immediately comparable - measurement of ESG parameters. With rating agencies incorporating ESG considerations into their underlying obligor assessments, we expect to see ESG parameters become all the more dominant in the structuring of CLOs.
So far, the US CLO market appears to be lagging Europe on ESG, but under the new Biden administration there is some hope that more incentive-driven regulation will be put in place.
If there is a harder regulatory push around structuring and investing in collateral pools where the US and Europe noticeably diverge on ESG standards, there could also be an element of arbitrage, but this has not arisen yet.
The CLO market is a great place to promote sustainable finance more generally because it has a proven track record through all stages of a credit cycle, with alignment across market stakeholders. We believe the sector can benefit from the rapid growth in ESG trends and that the resiliency of CLOs will continue to prevail.
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