Moody's: U.S., Europe, Asia-Pacific CLO credit quality strong in 2014

By Toni Weeks

San Luis Obispo, Calif., Dec. 6 - The credit quality of new collateralized loan obligations in the United States, Europe and Asia-Pacific will be strong in 2014, according to a new report titled "2014 Outlook: Global CLOs" from Moody's Investors Service, Inc.

The report covers transactions backed primarily by broadly syndicated loans (BSL) but also includes loans to small and medium-sized enterprises (SMEs) and loans from bank balance sheets, according to a Moody's press release.

U.S. CLOs

The credit quality of new BSL and SME CLOs in the United States will be strong in 2014, as their structures will continue to follow the CLO 2.0 template, the report said.

Moody's predicted that increased subordination will offset the negative effects of newly issued loans of lower average credit quality. Substantial credit enhancement and structural provisions that protect debtholders will augment new SME transactions, while amortization will enhance many existing BSL and SME CLOs.

"The primary risks to our outlooks stem from the shift in the loan market toward riskier borrowers," Moody's managing director Yvonne Fu said in the press release.

"The proportion of B3-rated issuers among speculative-grade borrowers has grown this year and is likely to continue growing in 2014.

"Nevertheless, new U.S. CLO structures will be sound, and the assets backing them will perform well, which will offset the negative effects of newly issued loans of lower average credit quality."

Optional redemptions are another positive trend, the report noted, but existing CLOs, specifically CLO 1.0 deals, could be subject to the risk that a portfolio's weighted average life could lengthen. Declining loan spreads would also be credit negative for existing CLOs.

While the agency expects 2014 issuance volume for both BSL and SME CLOs to be similar to 2013 levels, primary constraints on growth will come from the scarcity of Aaa (sf) investors and pressure on CLOs' excess spread. But amortization and redemption of older deals and market innovations will support primary activity, the report said.

European CLOs

Moody's believes the credit quality of new European BSL CLOs will be similar to that of deals issued in 2013. According to the report, European CLO 2.0 structures will remain more conservative than typical European CLO 1.0 structures, with shorter reinvestment periods and higher levels of equity subordination.

In contrast to new European BSL CLOs, new balance sheet CLOs in Europe will have a stronger credit quality than that of previous issuance, the agency predicted. Existing transactions will perform as they have in 2013, Moody's said in the report, suggesting that new loan originators will call for stricter lending criteria and enhanced performance stability. Some cash transactions will remain vulnerable to sovereign and operational risk, however.

In the agency's view, amortization will drive the performance of most existing European CLOs, although the effects on senior and junior tranches will vary. The report noted that exposure to borrowers based in the lower-rated peripheral euro-area countries is generally limited to 10% of the eligible portfolio.

The outlook for primary European BSL CLO issuance in 2014 is somewhat uncertain, despite the resumption of new issuance in 2013, the report said, with the main drivers of new issuance the availability of collateral and the impact of new regulations taking effect in 2014.

The issuance of balance sheet CLOs will again be low next year because of the gap between investors' yield targets and originators' cost constraints as well as the constrained capacity and willingness of European commercial banks to extend new corporate loans. Furthermore, origination will likely be restricted to a diminishing number of safe-haven domiciles in northern Europe, given the impact of the sovereign crisis on peripheral European nations.

Japan CLOs

Existing SME CLOs in Japan will benefit from the banks' supportive lending attitude to SMEs, which continue to amortize, the report stated. However, new issuance will be minimal in 2014, it added.

Asia ex-Japan CLOs

The agency expects balance sheet CLOs in Asia ex-Japan will continue to perform solidly despite the likely deterioration of credit quality of loans in some regions. These positive expectations stem from factors including the diversification by country and industry of portfolios, the safeguarding of portfolio credit quality by loan replacement criteria and the low project default rate due to continued GDP growth in major emerging market countries.

Moody's expects issuance in 2014 to be low because of an increase in regulatory costs. According to the report, regulators have increased the capital charges on investors holding structured finance securities, which will reduce the benefit of decreasing charges for originators.

The report is available at https://www.moodys.com/research/2014-Outlook-Global-CLOs--PBS_SF349028.

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