There have been several changes developing in the CLO market over the last few months; a reduction in tranche sizes, lower leverage, shorter reinvestment periods, shortened WAL and higher WARF. Will these be the new wave of CLO 3.0 characteristics, or just a response to deteriorating collateral quality and higher cost of capital?

During the Creditflux CLO Symposium held on 8 September in London, a diverse panel discussed "What will CLO 3.0 look like?". I was on the panel along with Vedanta Bagchi, Director, Commerzbank (Senior Debt Purchaser), Matthew Layton, Partner, Pearl Diver Capital (Equity Investor) and Matthias Neugebauer, Managing Director, Head of European Structured Credit, Fitch Ratings.

As we approach the mid-year mark of our new normal (pandemic market), it might be too early to say for certain how CLOs will perform in 2020, but many key themes presented themselves from a "print and sprint" concept, to the issuance of static deals. During the panel discussion, current conditions along with these concepts were not considered CLO 3.0 characteristics, but a strategy to close a deal or move a warehouse along during the present environment. However, the panel did discuss several key points that reflect more of a transition period, along with some evolutionary ideas:

• From an equity component, there continues to be a reduction in the overall cost of financing as we saw from 1.0 to a 2.0 CLO. However, the industry is not seeing any new concepts to reduce the cost of financing, like creating a dual tranche AAA similar to an ABS product as mentioned by Layton. Additionally, static deals, short call, etc. do not offer a good option for equity investors, as the deal will need to be reset in a few months adding to additional costs.
• During the CLO 1.0 to 2.0 CLO transition, rating agencies issued a moratorium on ratings, and reviewed, and updated their criteria, effectively becoming the 2.0 CLO series. An exposure draft is circling the market, but agencies appear very comfortable in the current credit risk in CLOs at this time. According to Neugebauer, when you see rating agencies update criteria, along with higher leverage, that essentially becomes the next CLO series, which we have not seen this year.
• From a senior investor standpoint, the biggest concern during the current crisis was the downgrade risk. Recent deals that have closed are returning to pre-COVID structure standards with new language around loss mitigation originally in the US industry. However, collateral quality, rebate of management fees, manager mergers and industry consolidation will be key topics to look at as the market begins to tighten. As new CLOs begin to ramp up, senior investments will look to the strength of the platform, credit team, documentation, and underlying collateral industry, according to Bagchi.

Although the industry is seeing new components and language appear in recently closed deals, the panel's opinion is that we are in a transition period, and not at the stage of labelling the next generation of CLOs. Paramount to the CLO industry is its ability to quickly adapt to a changing social, economic, and political environment, along with resiliency, as we have seen from the 2008 financial crisis, and pre- and post-COVID events.

Posted 21 September 2020 by Mark Bennett, Director of Compliance Analytics, IHS Markit

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This article was published by S&P Global Market Intelligence and not by S&P Global Ratings, which is a separately managed division of S&P Global.