Despite challenging conditions, European CLOs are still popular among investors as a high-yield alternative in a challenging low spread environment. Over EUR 40bn was deployed in 2019, a mixture of new deals (72%) and refinancings (28%). New issues were driven by a strong Q4, and topped EUR 30bn across over 70 deals, a 10% increase from 2018. Eight new managers entered the market, which was the highest level since the reopening of the market after the financial crisis.

“In 2020, we expect European CLO volumes to reach levels nearing those observed over the past two years,” said Benoît Vasseur, a director in the structured finance team of Scope Ratings and co-author of a report out today, “as investor demand will remain solid with ECB monetary policy set to remain accommodative. This will support the yield-enhancing nature of CLOs relative to other asset-backed segments.”

But there are potential risks on the horizon. “While we expect the asset class to stay strong in 2020, a number of risks could materialise, including deteriorating credit quality among sub-investment-grade corporates and tighter spread arbitrage,” Vasseur added. Spread arbitrage is at its lowest level since the financial crisis. CLO managers are increasingly challenged when structuring new transactions and may have to accept lower equity returns as deal leverage is not being raised.

On the European leveraged loan side, investor appetite was robust throughout 2019, as European high-yield issuers continued to display historically low default rates. But supply did not match such strong demand, as 2019 was the first year since 2013 where both primary and secondary activity decreased year-on-year. The lack of jumbo deals contributed mainly to the decline. This trend is closely linked to M&A, down 25% year-on-year in Europe in 2019.

“Corporates have been particularly cautious, fearing threats of recession and ongoing uncertainties about Brexit, while facing continuous pressure on their operating performance,” said Cyrus Mohadjer, an analyst in Scope’s structured finance team and co-author of today’s report. Cash holdings for both corporations and funds have increased as a result and could be used in LBO financing if markets become more stable in 2020. “This could help increase the net supply of leveraged loans that has already been picking back up in the last few months of 2019, following more opportunistic deals across Europe,” Mohadjer added.

The credit quality of the broad leveraged loans universe has worsened, however. Issuers have seen their financial leverage increase, with the share of underlying debt-to-EBITDA ratios above 6x now exceeding 35% of the outstanding universe compared to c. 20% in 2015.

The full report can be downloaded here.