Investors' dual interest in European, U.S. CLOs on the rise
U.S. and European CLOs share common characteristics.
They each contain primarily leveraged loan assets, are largely governed by the same documentation standards, and increasingly have the same roster of global managers at the top of league tables.
But both U.S.-dollar and euro-denominated collateralized loan obligations also retain unique attributes and performance indicators against their counterpart deals across the pond – such as the greater diversity of assets in U.S. deals, or the complex multicurrency and sovereign risks traits in European portfolios.
The multitude of differences is growing, and becoming more crucial to global investors who want to better discern variances in the market standards and performance of each as they increasingly dip their toes into both markets.
“We feel there are more dynamics in the market,” said Jian Hu, a Moody’s managing director for CLO/structured credit, esoteric and commercial ABS, explaining why the market differences warranted study. “We’ve seen increased interest in U.S. managers doing European deals … and U.S. investors [buying into] European CLOs.”
Hu said more investors have approached Moody’s in the past year asking about structural and regulatory differences, as well as credit performance challenges, between the two markets.
The two markets mirror each other in several ways. European and U.S. deals each typically have four-to-five-year reinvestment periods, prohibit investment in structured finance and synthetic instruments, and provisions to replace managers over collateral performance.
The new report however also highlighted differences such as the greater percentage of fixed-rate assets in European deals and the wider exposure to more companies and industries in the U.S. deals.
"The natural inclination is, in Europe, to do similar transactions to those they are doing in the U.S.," said Ian Perrin, associate managing director in Moody's structured finance group in London. "Sometimes the features need to be adapted to the market … because some of these things may be local to the US and these things don’t exist in Europe."
The primary difference is market size. The U.S. had 127 active managers in 2018, while 47 were issuing deals in Europe. Moody’s cited figures from the Bank for International Settlements estimating the U.S. leveraged finance market of high-yield bonds and leveraged loans at about $9 trillion, or 4.5 times larger than the European leverage finance market.
Moody’s noted more than 2,000 obligors have loans held in U.S. CLO portfolios, with $600 billion in outstanding assets, while European deals are spread 600 corporate borrowers with roughly €107 billion ($113.1 billion) in deal volume outstanding, according to Moody’s. Moody’s rated around $478 billion of the U.S. deals at the end of 2018, and nearly all the European offerings.
Europe is less diverse in assets, as well as managers. It has a greater concentration of outstanding assets under management among the top 10 CLO managers (50%) compared to the top 10 in the U.S. with only 29%.
“Europe's smaller manager pool and leveraged loan market mean that investors there have less opportunity to diversify their exposure to various assets and managerial styles,” Moody’s report stated.
Moody’s proprietary diversity scoring model shows U.S. deals are more widely dispersed among uncorrelated industries and assets, with an average score of 72 in the first quarter of 2019, compared to 52 but European deals.
But European managers have made improvements in the past year by delivering a more diverse set of debt assets into their deals. Moody’s says this is the result of “reverse Yankee loans,” or euro-denominated loans by U.S. companies “that represent a broader range of industries than typically available in European deals.”
Bond holdings in European CLOs leave more fixed-rate assets (around 6% of portfolio notional values) in European portfolios, compared to U.S. deals rated by Moody’s with around 0.2%. The bond holdings also expose European CLOs to more unsecured assets – which whittles away at the average recovery rate assumptions for European deals against the primarily secured assets of U.S. CLOs.
(U.S.-based CLOs structures generally do not hold bonds due to the covered fund provision of the Volcker Rule barring U.S. banks from holding ownership stakes in private-equity or hedge funds. Leveraged loans, unlike bonds, were exempted from covered-fund status, meaning CLOs could structure deals only with loans to retain business with banks, which are the largest purchasers of U.S. note tranches in CLOs.)
European CLOs make up for the weaker recovery rates by offering greater subordination levels for triple-A notes at the top of the capital stack than U.S. deals – providing a larger loss cushion for the senior notes in European offerings.
Sovereign risks are inherent in European deals, which are exposed to corporate obligors in 33 countries in multiple currencies. U.S. CLOs are generally limited to 20% exposure to non-domestic issuers. This risks are typically hedged with perfect asset swaps and currency swaps.
Note buyers of European deals might also pay close attention to the more widespread practice there of managers treating trading gains as interest proceeds rather than principal proceeds, which are considered more favorable to holders of the equity, or ownership, tranches of deals. “Such treatment enables managers to use trading gains to pay equity tranches instead of using those gains to invest in new collateral obligations or to pay down notes,” the report stated.
One of the more well-known differences is that European CLOs are subject to risk retention requirements – unlike U.S. CLOs that were freed from the Dodd-Frank Act’s requirements to hold skin in the game via a federal appeals court ruling last year throwing the standards out for U.S. managers.
Another key contrast between the deals is the future of benchmark rate transitioning. U.S. CLO managers are coping with the expected demise of U.S. dollar-Libor reference rates for their notes and loan assets, while European managers that rely on the euro-based interbank lending rate (Euribor) that will continue in a reformed form of a new short-term rate that has a compliance deadline beyond the 2021 drop-dead rate expected for Libor.