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Rethinking CLOs

November 2019

Modest improvements in the global economy and the broadening of collateral types for CLOs could usher in another record year for this market in 2020, says corporate trust expert Steve Hessler.

The Deutsche Bank Research team’s growth outlook forecasts a global bottoming out of business sentiment, which is likely to show modest improvements moving into 2020, with the risks of a near-term recession declining1. Additionally, interest rates are likely to remain where they are for at least the next 12 months.

In Federal Reserve Chairman Jerome Powell’s comments after the October Federal Open Market Committee meeting, lower rates would require a “material reassessment” of the economic outlook. Negotiations between China and the United States over trade disputes have evolved from a comprehensive agreement, to smaller phase one, phase two and phase three agreements. With the upcoming 2020 US Presidential election, pressure to reach an agreement may mount, resulting in a phase one agreement said the Deutsche Bank research note.

A potential increase in economic growth next year versus 2019, relatively benign liquidity markets and a possible trade deal, albeit slimmed down, between China and the United States elevate the prospect of a robust CLO market in 2020.

 

Dr Rebecca Harding

Steve Hessler

Director in the Corporate Trust team

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Dispelling fears

Risk in the CLO market is still cause for concern. In some corners, there are fears that CLOs might precipitate an economic collapse in the same way that residential mortgage backed securities (RMBS), held as assets by collateralised debt obligations, or CDOs, were a main cause of the 2008 financial crisis.

A major difference, however, is the collateral of a CLO versus those CDOs. Whereas the latter were ultimately exposed to mortgage loans to individual borrowers, CLOs are holding loans to corporate entities. Were a recession to occur – and one does not appear imminent – individual borrowers would feel the effects sooner in the form of layoffs and reduced income, thereby reducing their ability to pay their liabilities.

Corporations on the other hand, would have some time to adjust their business plans in order to continue servicing their debt, particularly bank loans, which stand near the top of the capital structure of a corporation. So one could conclude that the collateral backing yesterday’s RMBS and today’s CLOs are significantly different and do not warrant such a comparison. If there were to be a concern regarding securitisation structures, the market should look at today’s student loan asset-backed securitisations, or ABS, which are much more similar to RMBS transactions than CLOs.

 

Dearth of collateral to ‘self-brake’ the number of CLOs

Another thought suggests that the sheer number of CLOs may create economic issues. However, the dearth of collateral provides a natural brake on CLO formation. As the number of CLOs increases, the ease of sourcing collateral is negatively impacted. So, managers who typically might issue four or more CLOs in a given calendar year may be looking at issuing only one or two for the foreseeable future.

Further, the proliferation of first-time managers during the last couple of years will likely decelerate. Along with smaller CLO management firms, managers looking to launch their first CLO in 2020 may find it particularly difficult. Therefore, the unfettered issuance of new CLOs with poor performing collateral is unlikely. It is self-braking mechanisms such as these that could give investors comfort in the CLO structure.

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.

If you have to forecast, forecast often

Edgar Fiedler in "The Three Rs of Economic Forecasting –Irrational, Irrelevant and Irreverent" (June, 1977)

Broadening the scope

A potential trend in 2020 that bears watching is the broadening of the asset type away from the standard broadly-syndicated and middle-market loan CLOs. In addition to commercial real estate CLOs, project finance CLOs and those focused on companies that adhere to environmental, social and governance, or ESG, standards may become more prevalent.

With an anticipated improvement in the global economy, a benign interest rate environment, and generally healthy market conditions and a scaled down trade deal between China and the United States, the CLO market should remain resilient in 2020. Issuance should remain at least on par with 2019, and if additional collateral types become mainstream, we could see another record year.

As Edgar Fiedler wrote in The Three Rs of Economic Forecasting –Irrational, Irrelevant and Irreverent (June, 1977), “If you have to forecast, forecast often”. Stay tuned for a further projection ahead of the SFIG Vegas 2020 conference in February, 2020.

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Sources

1 See https://bit.ly/2qPCcGB at at dbresearch.com

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