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There have been several changes developing in the CLO market
over the last few months; a reduction in tranche sizes, lower
leverage, shorter reinvestment periods, shortened WAL and higher
WARF. Will these be the new wave of CLO 3.0 characteristics, or
just a response to deteriorating collateral quality and higher cost
of capital?
During the Creditflux CLO Symposium held on 8 September in
London, a diverse panel discussed "What will CLO 3.0 look like?". I
was on the panel along with Vedanta Bagchi, Director, Commerzbank
(Senior Debt Purchaser), Matthew Layton, Partner, Pearl Diver
Capital (Equity Investor) and Matthias Neugebauer, Managing
Director, Head of European Structured Credit, Fitch Ratings.
As we approach the mid-year mark of our new normal (pandemic
market), it might be too early to say for certain how CLOs will
perform in 2020, but many key themes presented themselves from a
"print and sprint" concept, to the issuance of static deals. During
the panel discussion, current conditions along with these concepts
were not considered CLO 3.0 characteristics, but a strategy to
close a deal or move a warehouse along during the present
environment. However, the panel did discuss several key points that
reflect more of a transition period, along with some evolutionary
ideas:
From an equity component, there continues to be a reduction in
the overall cost of financing as we saw from 1.0 to a 2.0 CLO.
However, the industry is not seeing any new concepts to reduce the
cost of financing, like creating a dual tranche AAA similar to an
ABS product as mentioned by Layton. Additionally, static deals,
short call, etc. do not offer a good option for equity investors,
as the deal will need to be reset in a few months adding to
additional costs.
During the CLO 1.0 to 2.0 CLO transition, rating agencies
issued a moratorium on ratings, and reviewed, and updated their
criteria, effectively becoming the 2.0 CLO series. An exposure
draft is circling the market, but agencies appear very comfortable
in the current credit risk in CLOs at this time. According to
Neugebauer, when you see rating agencies update criteria, along
with higher leverage, that essentially becomes the next CLO series,
which we have not seen this year.
From a senior investor standpoint, the biggest concern during
the current crisis was the downgrade risk. Recent deals that have
closed are returning to pre-COVID structure standards with new
language around loss mitigation originally in the US industry.
However, collateral quality, rebate of management fees, manager
mergers and industry consolidation will be key topics to look at as
the market begins to tighten. As new CLOs begin to ramp up, senior
investments will look to the strength of the platform, credit team,
documentation, and underlying collateral industry, according to
Bagchi.
Although the industry is seeing new components and language
appear in recently closed deals, the panel's opinion is that we are
in a transition period, and not at the stage of labelling the next
generation of CLOs. Paramount to the CLO industry is its ability to
quickly adapt to a changing social, economic, and political
environment, along with resiliency, as we have seen from the 2008
financial crisis, and pre- and post-COVID events.
Posted 21 September 2020 by Mark Bennett, Director of Compliance Analytics, IHS Markit
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