Articles & Interviews

Articles & Interviews

2 November 2023

European Structured Credit: an Attractive Risk-Reward in a Weakening Environment

What is a CLO?

Collateralised loan obligations (CLOs) offer investors many potential benefits, including diversification, structural protections, low sensitivity to interest rate increases, and higher average yields than similarly rated traditional fixed income.
Indeed, CLOs are actively managed securitisations backed primarily by a pool of 150-300 BB and single B rated issuers’ senior secured loans and bonds.
CLOs are also primarily floating-rate products and are typically issued to take advantage of the funding gap between asset yields (e.g. loan spreads) and liability costs (e.g. CLO tranche spreads).
Finally, CLOs are structured with a number of debt tranches – typically rated AAA down to single-B – as well as an equity tranche. Interest or principal payments are made first to the most senior bonds, and residual interest cash flow, if available, can be passed to the equity tranche. Conversely, losses in the collateral pool of loans are first absorbed by the most junior tranches, meaning the equity tranche would receive first losses.

Historical CLO Tranche Impairment (Default) Rates?

Most BBB CLOs are structured with 20% credit enhancement, which means that 20% of the collateral pool would have to default at a 0% recovery rate for a BBB tranche to take a principal loss. Regarding BBB Euro CLO, this scenario has historically never happened (as per table below).

Historical CLO Tranche Impairment Rates Have Remained Low

Why are European BBB CLOs Attractive in the Current Market Environment?

As mentioned above we tend to favour investments in the BBB tranches for several reasons:
1. Strong credit protection against collateral pool defaults.
2. Attractive valuations vs similar rated corporate. In our view the spread premium is more than compensating investors for the credit risk taken in CLO securitisation. 
3. Attractive total returns: almost 9% yield in Euro with Euribor 3M now sitting at 4%.

CLOs BBB Trade at an Attractive Premium vs Similar Rated Instruments

How are the Fundamentals?

We are heading into an economic slowdown with strong fundamentals for European corporate issuers which should effectively mitigate the risk of loan defaults. Notably, HY European issuers have recently managed to reduce leverage and strengthen their balance sheet in response to the post-COVID surge in demand. An active management (a characteristic inherent in current CLOs structure) is however required as the high inflation environment is expected to exert pressure on profit margins, while rising interest rates will increase borrowing costs. 

Vincent Ollivier
Credit Portfolio Manager




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