While European CLO managers have suffered less from tightening collateral spreads than their U.S. counterparts, some market players are noting a trend of borrowers in the European loan market becoming increasingly leveraged.
Unlike in the U.S., European borrowers are placed in one of several credit quality tiers, and charged an associated "fixed" spread - currently 325 basis points for the loans that end up in CLOs. While the fixed spread method, as opposed to name-by-name pricing, has kept the arbitrage intact in the last few months, originating banks are lending more aggressively.
"Leverage ratios have been creeping up a bit, but the collateral spread has remained stable," said Fritz Brown, a managing director at Deutsche Bank Securities, during a CDO panel at last week's IMN Global ABS conference in Barcelona.
One of the challenges for the European CLO market is that there is relatively little data on the loans. In fact, one panelist said that meaningful loan data only goes back three years, which makes it difficult to peg underlying collateral trends from a historic perspective.
From what is available, it would seem default levels are quite low, according to Marjan van der Weijden, a senior director at Fitch Ratings. "This is part of what has driven the popularity of the product," she said.
Investors are concerned, however, because much of the deal modeling, analysis and rating criteria for European CLOs is based on U.S. statistics (in the absence of other available data).
Are managers just buying
the market?
As with other CDO sectors, European CLOs are constrained by the availability of collateral while ramping up. Over the last year, a large portion of the loans have been originated in Germany, followed by the U.K and France. Two years ago, more loans were coming out of Italy.
Because of this sort of regional granularity and other vintage characteristics (such as the increased leverage), some have argued that ramp-up periods should be longer, so that managers can capture more than one market cycle.
Furthermore, panelists described the loan market environment as "clubby," where the availability of collateral is often based on relationships. "It's all about access to assets," said Dagmar Kershaw, who heads the CDO group at Prudential M&G. "The better managers have better access to assets."
Structural changes
There are a few structural changes of note being implemented in the newer CDOs. Many deals are being structured with 12 years or longer final maturities, as opposed to the previous 10-year finals that investors had become comfortable with. This is partly a reflection of the longer maturities of European loans, particularly for mezzanine collateral, which European managers have increasingly turned to as a way to capture increased yield.
Current European CLOs are including between a 10% and 20% bucket for mezzanine loans compared with 10% or less a few years ago.
The problem with a 10-year final maturity is that, for most deals, it limits the assets a manager can buy during its reinvestment period, which is typically five years for European CLOs. For example, a manager loses the ability to purchase a loan with a seven-year term after year three if the CLO's legal final maturity is 10 years.
Prepayments have been a significant challenge for collateral managers. Duke Street Capital's 2003 Duchess I, for instance, had 28% of its portfolio prepay, said Ian Hazelton, chief executive officer a the firm. Hazelton said he had heard of other deals facing 35% prepayments.
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