Octus on Credit: European CLOs: Spreads, Supply, and Regulatory Shifts

The CLO market on both sides of the Atlantic has regained nearly all the ground lost since late February despite elevated geopolitical risk – though new issue spreads on the European side are lagging behind with triple-As in the low to mid-130 bps area. With secondary spreads flat over the last week, the potential for further tightening seems limited and there are signs of resistance at current levels for seniors and signs of widening in price guidance for European mezz tranches. Yet investors have had enough leverage to push back on aggressive features, such as Carlyle’s attempt to bring an unusual fee structure to a European new issue.

Loan supply has picked up but margin compression is putting pressure on the CLO equity arbitrage, a trend that seems likely to continue given the large CLO pipeline, a record number of open warehouses, and limited M&A activity. With most new deals offering no original issue discount, the opportunity to build par during the post-tariff volatility has passed.

The market has been digesting the European Commission’s proposals on reforming the securitization framework since they were unveiled in June. The proposals present a mixed picture for CLOs and key provisions on capital requirements for insurers are still to be formally revealed. While the draft legislation promises a streamlining of due diligence and reporting requirements, it would also reclassify European CLOs and potentially U.S. ones as public deals, and would increase transaction costs by requiring all deals to submit their transparency data to repositories.

The biggest capital benefits offered, even if in theory available to CLOs, would only be available to originator banks. The proposals do not mention the sole purpose test for risk retention, offering no respite from the uncertainty that has bedeviled the market since the European Supervisory Authorities’ surprise intervention at the end of March.