Instead of waking up to the prospect of buoyant markets, and the expectation that primary activity would restart in the wake of a Remain vote in yesterday’s referendum, CLO players were instead rudely awakened with the early morning news that the U.K. has voted to leave the European Union.
Now all bets are off when it comes to primary issuance as players try and make sense of the outcome, and figure out their next steps. And the handful of managers — Accunia among them — who were gearing up to price deals will likely have to wait and see how investors react.
That’s a deep shame, given how the market had recovered from the troubles of the first quarter. Had the vote gone the other way, June could have notched up the highest tally of CLO issuance this year, with several more transactions gearing up to price this month.
Month-to-date issuance currently stands at €1.64 billion, while year-to-date issuance stands at €7.21 billion, according to LCD, an offering of S&P Global Market Intelligence.
There was a clear sense of shock among market players this morning, but while some have forecast the migration of key asset manager operations to Ireland and/or the Continent, for the majority it is far too early to draw any conclusions, especially given the perceived length of any Brexit process. Instead, most prefer to focus on the positives — and perhaps dealing with so many regulatory knockbacks over the years has embattled them. A period of uncertainty and primary market standstill is inevitable, but that there are many reasons why issuance should resume again.
The fact that U.K. corporates form a smaller share of the European CLO market is a positive factor in the event of a U.K. recession. J.P. Morgan CLO research analysts estimated in February that European CLO 2.0s hold roughly 13.2% in U.K. assets, while Citi’s CLO research analyst Ratul Roy in a client Credit Flash today puts the average U.K. corporate risk at roughly 11% of a typical portfolio. Roy does, however, note that two of the five sectors these U.K. assets are concentrated in are retail and banking, which are likely to be more volatile than the other three — namely chemicals, food & beverage, and hotel & leisure.
Primary spreads, having marched all the way in to E+128 at the AAA level, are expected to widen again, which could impact arbitrage, although on the asset side presumably the news will stem further opportunistic transactions in the loan market. “Long-run demand will be driven by how much CLO spreads widen relative to loan spreads, ie. by future arbitrage, and the default environment not worsening significantly,” said Deutsche Bank CLO research analysts in a note published last night.
For those with a warehouse open meanwhile, the current volatility may present a good opportunity to get ahead with the ramp via the weaker loan and bond secondary market. “If you have capacity to deploy cash, it’s a good buying opportunity. But it is hard to see any new-issue deals coming for some time,” said one manager.
Sources suggest a number of new warehouses have been signed in the run up to the vote, although others had been held back by their more cautious first-loss providers, who preferred to wait until after the referendum before committing to a new facility. “I have been quiet these past few weeks,” said one investor. “I have cash stored up ready to invest in the credit markets, but I would have just looked stupid if I put the money to work the week ahead of the vote and it went the wrong way.”
The decision to wait looks eminently sensible now, but players remain hopeful that investors will remain engaged. Ramping conditions may have improved from a secondary perspective, but the key question here is the plausibility of the CLO takeout, and how much investors are going to care now about the legal ambiguity of a manager potentially based outside the EU, versus in two years’ time, noted one manager.
CLO investors will be a key part of restarting primary, and many have money to put to work. Some, especially at the lower part of the stack, may prefer to invest in the CLO secondary, but senior paper is harder to source here. The ECB-driven hunt for yield may also keep European investors focused on the market, even if some more-conservative parties hold back.
Citi’s Roy urges caution regarding secondary opportunities, noting that European CLO holders may not have the appetite for volatility. “With dealer balance sheets likely to be constrained, spread swings are likely to be amplified across the entire stack.”
Regulation and risk retention is the other key issue — and ironically concern around Paul Tang’s STS proposals pales in comparison with the huge task of ahead from a regulatory perspective. “Even if Brexit eventually results in retention requirements not being part of U.K. laws, they still of course will apply for EU investors,” said Franz Ranero, partner at A&O. “My concern is that yesterday’s vote puts us on the back foot in the current political dialogue regarding securitisation regulation, and somehow seen as lesser stakeholders.”
U.K. CLO managers have discussed with their legal counsels the loss of passporting privileges that allow them to qualify as sponsors for risk retention, and how to alleviate any investor concern around this issue to try and help get the primary market moving.
“Expect pre-baked originator switch mechanics to be included in all sponsor structures and less focus on the Tang report,” said John Goldfinch, partner at Milbank. “Loan prices are down, so there are lots of cheap assets to purchase, and it is difficult to find a more stable product for generating real return than a CLO, so I do see some positives, oddly enough.”
The negotiation of bilateral agreements between the U.K. and E.U. concerning the CLO market is considered achievable during the two-year exit withdrawal period, given CLOs represent a key source of funding for European corporations. Meanwhile, should the U.K. successfully negotiate staying in the EFTA, then the pressure is off completely, sources said. — Sarah Husband
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This story first appeared on www.lcdcomps.com, an offering of S&P Global Market Intelligence. LCD’s subscription site offers complete news, analysis and data covering the global leveraged loan and high yield bond markets. You can learn more about LCD here.