July 18, 2016 - July 18, 2016 – Three weeks after Brexit rattled the world, CLOs are back and are adjusting. Secondary spreads have tightened, primary issuance has returned and UK CLO managers are contemplating how to do risk retention compliant deals if they are no longer “European” managers.

Brexit clearly shook the CLO market. ThomsonReuters LPC’s Leveraged Loan Monthly shows that asset prices in both US and European CLOs dropped last month. And, as a close comparison of slides 57 and 58 reveals, European CLOs were (appropriately) hit harder. Average bids on US CLO assets dropped 46 bps to 95.27, while European CLO assets slid more than a point to 95.15. It was the first time in nearly a year that US CLO assets were priced higher than their European counterparts. Pressure also returned to the CLO secondary, with note spreads widening two bps at the top of the stack to 50 bps at the bottom, Wells notes. Meanwhile, both bond and CLO issuers warned that Brexit could affect earnings and debtholder returns, TR-LPC reported.

But markets are shaking off fears and it appears that CLOs may be back in vogue. A recent survey by Creditflux showed that many pension funds and family offices felt that CLOs were the “best investment in credit”. In that case, it should be completely appropriate that CLO spreads at the bottom of the capital stack have tightened back inside their pre-Brexit levels (though the top of the capital stack remains a bit wider), Wells data indicates. Deutsche adds that the global search for yield has flattened manager tier pricing, with Tier 1 managers tightening less than others. 

The primary market has revived as well. In the US, Sound Point Capital Management on Thursday priced a twice-upsized $722 million CLO. This brings July US CLO issuance to $1.79 billion in four CLOs, LCD wrote. This is on top of $6.6 billion in June CLO issuance, the highest month of the year. But don’t celebrate just yet. At $28 billion, US CLO issuance is still down 54% from the same period last year. Most of the decline is due to market disruptions – and, perhaps, a paucity of collateral – but risk retention does matter. Wells Fargo’s Salmagundi notes that the 2016 issuer landscape has shifted to favor larger managers. Nearly 40% of the managers doing deals this year issued at least three CLOs in 2015, while another 22% issued two deals last year. Still eight managers that didn’t issue CLOs last year have tapped the market this year. (To be fair, these were generally managers that have a capital source.) So, where does the risk retention count stand? As the LSTA Chart of the Week illustrates, at least 44% of 2016’s US CLOs are believed to have met risk retention rules either in the US (20%), Europe (8%) or both jurisdictions (17%).

On the other side of the pond, the European CLO market is reviving as well – albeit with a change, LCD wrote. As noted in the July 8th LSTA Newsletter, Brexit complicates matters for European CLOs. Euro CLOs are mostly done by UK-based managers and – as the Chart of the Week demonstrates – typically have met the risk retention rule using the “sponsor” method. Alas, the sponsor method is only available for “European” managers – which UK managers may not be after Brexit. In turn, LCD wrote this week that more European managers are opting to use the originator method, which is (currently) a risk retention option that works for non-European managers. CVC Credit Partners priced its second originator CLO of the year last week; admittedly, this is not really a test case as CVC historically has used the originator method. However, 3i may be switching from a sponsor CLO to an originator CLO for its next European CLO. Meanwhile ICG has switched its upcoming US CLO to an originator structure to ensure compliance with European risk retention rules. The “originator-switch” solution, apparently, is easier than managers expected. However, the originator solution only works if the European market doesn’t go “Full Tang”- e.g., 20% risk retention, with only European managers and investors permitted to participate, period – under the final STS rules. That, of course, could leave UK CLO issuers fully exposed.

The CLO conversation will continue into the fall, with LSTA General Counsel Elliot Ganz participating in Euromoney’s 4th Annual CLO Congress in Barcelona on September 20th and LSTA EVP Meredith Coffey moderating a panel at IMN’s ABS East in Miami on September 18th

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