“Risk-off” is never good for structured finance, and the reaction to Britain’s vote to leave the European Union is no exception.
The Brexit vote win took the financial markets by surprise, prompting knee-jerk reaction and spike in volatility, and investors and issuers are now looking to re-set and find a new reference point.
Analysts at Bank of America Merrill Lynch see a material differentiation between the U.K. and Eurozone markets. In the former, they expect a near-term suspension of issuance and low secondary activity with moderate spreads softening. In that latter, they expect limited issuance restricted to paper eligible for sale and repurchase agreement with the European Central Bank and larger differentiation between core and periphery.
“The surge in volatility and near-term market overshooting (given the markets were not positioned for this outcome) will depend on policy response, which is likely to be mainly monetary in the U.K. (interest rate cut and quantitative easing), and a combination of monetary and fiscal in the Eurozone,” a report published by the firm over the weekend states.
No surprise, the initial policy response, on both sides of the Atlantic has been the provision of additional liquidity.
Collateralized Loan Obligations
The primary risks to U.S. CLO investors are price volatility and a potential increase in recession probability, according to Wells Fargo. The bank believes that middle-market collateral may be more protected from U.K. and European risks, but a small number of specific borrowers may have outsized exposure, due to reliance on specific European / U.K. suppliers or customers.
U.S. and Euro CLO secondary trading and primary issuance may slow as investors wait to see how changes in market sentiment will filter down to the CLO market.
“Specific to U.S. CLOs, we believe a risk-off move could produce increased loan fund outflows, leading to lower loan prices. We also believe the uncertainty could lead to even less new net loan issuance, if corporations postpone acquisitions, mergers and buyouts,” analyst David Preston wrote in a report published Friday.
“However, increased quantitative easing efforts may drive increased demand for higher yielding assets such as AAA CLOs. Overseas investors may seek out U.S. assets, although currency fluctuations could influence Asian investors’ view of U.S. and Euro CLO purchases.”
Intex data show that 488 U.S. CLOs hold a combined $2.4 billion in exposure to U.K.-based issuers; of the U.S. CLOs holding U.K.-based assets, the median exposure is 79 basis points. The largest U.K.-based holding in U.S. CLOs is Virgin Media, with a combined $457 million, followed by Hyperion Insurance ($252.6 million).
In Euro CLOs, 207 CLOs hold a combined €7.4 billion in exposure to U.K.-based loans, per Intex. Median deal exposure is 13.6%.