The CLO Machine is Slowing Down

After the summer break the first two primary CLOs are being marketed with BlackRock and Fair Oaks looking to price €300m and €350m deals, respectively, in the next week. Price guidance suggests the lead managers expect reasonable demand, and given the lack of supply, that’s probably a fair assumption. The CLO primary market has taken longer than expected to get going this month, which may point to lower issuance for the rest of the year.

In 2019 the CLO machine delivered well over €30bn of new CLOs, a post-crisis record. This year started out in a similar vein, aided by healthy leverage loan supply, but from March onwards there has been a significant slowdown for obvious reasons. January looked to be extremely busy for leveraged loan investors, but half of the primary supply came from re-pricings of existing deals rather than new loan stock; great timing for those companies, it must be said. Of the €39bn of European leverage loan issuance up to the end of August, some €15bn was issued in January, almost as much as all the supply between February and June. The knock-on effect of this meagre loan supply is that there hasn’t been much to buy for CLO managers looking to fill their outstanding warehouses and replace prepayments in their existing CLOs.

The primary market for CLOs themselves has been a little bit more steady; clearly CLO managers have been able to ramp their deals for a long period of time so have had less disturbance from the drought of loan supply recently, but this clearly impacts future issuance. Recent primary deals have been smaller and some of the larger CLO managers have been on hold for a while now. Having spoken to most of the largest arranging banks we believe most of them do have deals in the imminent pipeline, though most of those warehouses were set up pre-COVID and we have heard that setting up new warehouses has been more tricky (the banks charge more and generally have less risk appetite).

After the pipeline for the next few weeks supply will probably reduce even further into the fourth quarter, and the slowdown will probably last until at least the first quarter of 2021. Geoff Horton, Barclays’ global CLO strategist, has recently revised his full-year 2020 forecast for net supply to €15-18bn, which we think this is a reasonable forecast. If spreads tighten further then €20bn of net supply isn’t impossible either, but that’s only another 15-20 CLOs issued in 2020 and a significant drop from last year.

There are still plenty of potential bumps in the road (Brexit, the US election, COVID-19 developments and so on) but the positive technical created by dwindling supply has the potential to push spreads tighter in coming months. CLOs should outperform mainstream credit as a result, especially as fundamental performance has improved over recent months.