European Structured Finance 2017 Review and Outlook: 2018 expected to be another good year, underpinned by solid credit performance.
2017 was a good year for securitised products: ABS funds performed well and a major European regulation creating simple and transparent securitisation was approved. 2018 is expected to be another good year, with very limited concerns about macroeconomic risks – the key driver for ABS performance. Political risk looks likely to be the key source of volatility and potential mark-to-market hits next year. The credit cycle is not expected to turn until 2019, although this may well happen earlier in the UK.
Securitised products were supported throughout 2017 by the search for yield – other fixed-income products of similar rating typically have much lower yields, often negative ones. These products are now increasingly appealing to investors looking to diversify away from fixed-rate bonds in a context of rising central bank rates or to hedge against a possible pick-up in inflation.
“The floating rate characteristic of European ABS and CLOs has been the major driver of our inflows this year, notably in Amundi ABS Fund,” said François Morin, a portfolio manager at Amundi. “We believe that this trend will continue in 2018 in the context of monetary policy tightening.”
Securitised products also turned out to be quite stable during the few bouts of volatility that affected other markets during the year, even benefiting from a flight to quality, according to traders.
Spreads may have often been viewed as too tight by investors, but the tightening could be beneficial to issuers next year. “ABS spreads are notably lower than they were one to two years ago, but that’s a good thing,” said Mike Li, portfolio manager at Dynamic Credit. “Given the negative net supply of ABS, tighter spreads will encourage issuers to return to the market and therefore increase much-needed supply.”
Stable supply volumes in 2018
Volumes across asset classes are expected to remain broadly the same as in 2017, with possibly a pickup in UK RMBS issuance – but views on this latter segment vary.
Morgan Stanley analysts expect gross issuance of €72bn next year, about 8% below 2017 – a volume that would keep net supply modestly negative. “Current valuations suggest that EU ABS is approaching an inflection point. However, the technical backdrop remains supportive and fundamentals stable,” the analysts noted. 2017 placed issuance is expected to be just above €80bn, according to MS estimates.
The analysts say they are “baking in better momentum versus 2017 for UK prime, peripheral RMBS and NPL ABS and slower volumes for UK non-prime RMBS”.
Deutsche Bank analysts, who also saw in 2017 some “early pointers to a market approaching peak cycle”, expect primary issuance to potentially reach €95bn next year, up c.15% versus 2017, but with downside risk. Bond redemptions in 2017 were estimated at c.€97bn, outstripping new supply. “We expect 2018 will herald the first time since the crisis that the European securitisation market will not shrink,” DB said, as long as issuance hits the mid €70bn mark.
Deutsche Bank analysts’ 2018 issuance forecast
Citi analysts have a base-case forecast of €88bn of placed issuance, almost €10bn more than in 2017. The forecast range however is relatively wide, at €75bn-€100bn. The phasing out of the Bank of England’s funding schemes in early 2018 could increase RMBS supply. “We expect traditional lenders to tap RMBS markets in greater force during 2018 because of the winding down of UK schemes. This amounts to a new dynamic in the market, as up to this point, legacy supply has been a big driver for UK RMBS,” Citi pointed out.
BAML analysts expect 2018 European Structured Finance volumes to be similar to the c.€85bn (for placed issuance) seen in the year 2017 to end-November, the date of the release of their outlook. This suggests another year of net negative supply of SF bonds, the tenth in a row, they noted.
Rabobank expects €75bn-€80bn of non-retained European ABS supply in 2018. “This is roughly in line with issuance in 2017, but the composition of deals is expected to change,” Rabobank analysts noted. They expect the majority of issuance to be in the form of RMBS, followed by Auto ABS and arbitrage CLOs. However, within RMBS, the analysts anticipate an increase in the supply of UK Prime RMBS as well as a c.25%-30% rise in non-retained RMBS issuance from the Eurozone periphery; but non-retained Dutch Prime RMBS issuance is expected to decline (€4.25bn vs. c.€6bn) as more sellers are turning to cheaper funding alternatives, especially covered bonds.
The unwinding of the European Central Bank’s ABS purchase programme is unlikely to be a game-changer – even if the ECB acquires about half of the bonds directly in the primary market. BAML analysts think the ABS market can cope with this gradual withdrawal “as long as the holdings are allowed to gradually repay or sold in a measured way”.
According to Dynamic Credit’s Mike Li, the “supply of new issue in ABS will be key in 2018”. He pointed out that this year 75% of issuance has come from non-bank lenders. “It’s important that we see more traditional issuers come back to market as that will prove that they view securitisation as a long-term funding strategy. If issuers with different funding options choose ABS, we’ll see a better variety of originators, better secondary market and an overall better functioning market,” Mr. Li said.
CLO new issues
Leveraged loan CLOs are expected to again be one of the largest asset classes within securitised products, behind RMBS and close to (or slightly ahead of) auto ABS, with forecast volumes in a broad €17.5bn-€25bn range.
JPMorgan analysts forecast €25bn of gross European CLO supply in 2018, or +€20bn in net terms. This would make CLOs “one of the few euro-denominated securitised sectors with positive net supply,” they noted.
Morgan Stanley analysts forecast €20bn of issuance – €44bn including refis and resets. Net issuance is expected to be c.€13bn. Their new deal origination forecast for the US is $100bn. The analysts do not foresee a sharp increase in corporate borrowing activities financed by leveraged loans in Europe, leaving CLO managers challenged from an asset-sourcing standpoint. Morgan Stanley also pointed to increased competition for assets from Separately Managed Accounts (SMAs) and other forms of non-CLO loan investors.
BAML forecasts €18bn of new issuance for 2018. This is similar or slightly lower than 2017 volumes, depending on how many more deals price before year-end, they said. “However, if we see another period of divergence between loan and CLO spreads as in mid-2017, we could see issuance volumes surpass this level,” they said.
Citi analysts believe that the arbitrage will be sufficiently attractive to be able to support a €22bn-€26bn year of gross issuance. Gross issuance during 2018 will depend on the volume of loan issuance and on the available excess returns for CLO equity holders, they said.
In their view, junior mezzanine tranches are “vulnerable to supply indigestion”, but senior tranches are expected to continue to be supported by a lack of alternative structured finance issuance and robust demand for secured floating rate assets.
Deutsche Bank analysts predict €20bn in leveraged loan CLOs, while Wells Fargo forecasts €17.5bn of CLO issuance in euros for 2018.
According to CapitalStructure’s data, CLO new issuance reached €19.5bn in 2017, above the €16.8bn recorded in 2016 and c.€13.5bn in 2015.
Resets and refis
New issuance was only part of the CLO story. Refinancings, resets and reissuances were another major theme of 2017, reaching about €23bn-€24bn. By mid-November 2017, nearly every transaction which had passed its (typically two-year) non-call date had either been called or reset, or had at least some of its tranches repriced or refinanced, BAML noted.
BAML expects refinancing and reset activity to continue in 2018. 2016 deals generally priced at the widest levels of the 2.0 era, meaning that there is a greater incentive for equity investors to bring those coupons and coupon spreads into line with new-issue pricing as those deals exit their non-call periods, they said.
Moody’s recalled that it rated 39 CLOs that closed in 2016, nearly all of which will exit their non-call periods in 2018. Based on Triple A spread levels as of November, 30 of those deals would save 30bps or more in a refinancing, including 26 that would save 40bps or more, the rating agency estimated.
However, the absolute volumes of reset and refinancing issuance is likely to be lower, given that there is no backlog of deals to be refinanced (as in 2017, deals from the 2013 to 2015 vintage deals were being refinanced), BAML analysts noted.
DB analysts think resets and refinancing could decline to €15bn, while Morgan Stanley has a forecast set at €24bn. In both cases this is a decline, but only a modest one for Morgan Stanley.
Intense reissuance activity may be reshaping the CLO product, at least for sub notes. According to Neil Basu, managing partner and CEO at Pearl Diver Capital, the nature of CLO equity is changing into a permanent coupon-bearing instrument rather than something that is priced based on a call at a fixed point in a CLO’s life. “This is happening because CLOs are increasingly likely to go through multiple resets,” he said. “As a CLO exits its reinvestment period, control investors are able to reset and extend the life of a CLO by another four years,” Mr. Basu said. “Although multiple resets are not a given in every deal, especially as each new reset requires more capital to be pumped into a deal, we are already seeing deals that have been refinanced once and then subsequently reset. There is also the new concept of repacks.”
Mr. Basu suggested that CLO equity is therefore becoming a long-term 12% coupon instrument, which will continue to provide that coupon as the last call pillar is pushed further into the future. “As a result, we may see the pricing approach change,” he said. Mr. Basu expects high volumes of refinancing and resets in the CLO market in 2018.
CMBS was more of a niche product in 2017. Deutsche Bank analysts observed that “it is difficult not to contend that the real estate lending markets have reached a new, lower leverage equilibrium where the CMBS 2.0 market is struggling to find its permanent place at the table, flitting in and out of competitiveness with certain sections of the banking market.”
BAML analysts estimated issuance at €3.5bn this year. But the 2017 volumes include single-tranche private deals. Taurus 2017-2 was the only public deal with credit tranching – Taurus 2017-1 IT was private.
“We think Taurus 2017-2 UK marks a re-opening of the originate-to-distribute issuance model and could be followed by deals from a number of conduit programmes next year,” they said. BAML thinks there could be half a dozen conduit deals issued next year at a conservative average deal size of €200m-€300m, which could bring an additional €1.5bn or more of issuance next year compared with 2017.
In BAML’s view, at current CMBS spread levels, CMBS could be viable in the UK and potentially in Germany for non-prime property, but not for prime property in either country. The analysts also think that some US CMBS investors could be attracted to European CMBS next year, particularly at the Triple A level where Europe offers higher spread.
BAML analysts forecast that CMBS issuance could be around €5bn in 2018. Morgan Stanley forecast €1bn of issuance next year, versus an estimated €0.4bn in 2017. DB analysts expect €5bn of CMBS. They think new deals could emerge, securitising loans of c.£25m secured on “quite decent” UK regional assets. These types of deals could be “viewed as something of a hybrid between a conduit CMBS and non-conforming RMBS transaction by the market, with potentially pricing to match. Such a product could be viewed as a CMBS 3.0 type product transaction by the market”, they said.
Earlier this year, CapitalStructure reported that Goldman Sachs was actively originating small sized UK regional CRE loans with a view to securitisation.
Moody’s expects originate-to-distribute CMBS originators to focus on loans with higher margins, driven by riskier features such as weaker property quality, non-standard property types or non-core jurisdictions, but not necessarily higher leverage. CMBS issuance driven by balance sheet management strategies will be primarily attractive to lenders with large CRE books, where CMBS transactions could be an efficient alternative to individual loan syndication or could help regulatory capital management, in its view.
2018 looks promising, but analysts struck a note of caution. Beneath the surface, there are points of tension, said Morgan Stanley analysts, who expect those points to “begin to emerge in 2018, mostly on the policy front – the Fed hikes three times, the ECB starts to taper its bond purchases, and BoJ policy becomes less accommodative later in the year”.
Deutsche Bank analysts, meanwhile, noted that the “last number of years have seen a near universal unidirectional improvement in credit fundamentals”. They now expect “this trend to slow and in certain cases – deals backed by more levered borrowers in the UK and the European CLO market for example – we see peak cycle risks emerging in the next 12-24 months.”
But any change is likely to be gradual and no sweeping rating actions are expected in the near term. The 2018 outlook for European Structured Finance ratings at Fitch is stable, supported by strong economic growth and positive consumer and business sentiment in the Eurozone.
However, the rating agency is more cautious about the UK. Fitch has a mixed stable/negative outlook for the underlying assets within UK auto and UK credit card ABS, UK prime CMBS and UK non-conforming RMBS, and a negative outlook for UK buy-to-let RMBS. It has a stable outlook for prime residential mortgages in the UK.
Fitch noted that “Brexit uncertainty plus a heightened risk of rate rises means that most asset performance outlooks are stable/negative”. Some are directly caused by Brexit risks, such as property price pressure (particularly in and around London) while others, such as rising household indebtedness, are more sensitive to rate rises but could be magnified by Brexit.
Commenting more specifically on CLOs, BAML said that many market watchers have cautioned against the UK retail and consumer sectors, as well as the healthcare sector in 2018. BAML analysts noted that, “given the concentrated nature of the leveraged loan market, this could cause the default rate to increase from current low levels, but we think CLO credit performance should remain strong, with potential for some widening in performance tiering across managers”.
Taking exposure to UK consumer sectors for example, BAML estimates an average 4.4% exposure across managers, but this is as low as 0.0% for one manager and as high as 10.7% for another.
Moody’s thinks existing deal performance will remain strong in 2018 amid a stable macroeconomic environment in which all of CLOs’ largest sector exposures have stable outlooks. CLOs rated by Moody’s have minimal exposures to the sectors expected to be most troubled in 2018 – on the one hand, the key sectors to watch are media, advertising, printing and publishing (2.02% of all European collateral), and, on the other hand, the oil & gas sector (only 0.02%). Fitch expects stable ratings for leveraged loan CLOs as default rates remain below historical averages, helped by record low interest rates and declining margins. The vast majority of CLO 2.0s are still in their reinvestment period, with a portfolio par amount above the reinvestment target par threshold, it said.
Nevertheless, a few have already made the headlines during 2017 and investors note that the list of names to monitor seems to be expanding quite rapidly (Concordia, Deoleo, New Look, Altice, etc).
More broadly, Mr. Basu said there are increasing risks coming into the system because of the end of economic stimuli and tightening of rates. “But on the other hand, credit fundamentals are still OK. We don’t foresee any sharp spikes,” he said. “We’ve been calling the end of the cycle for quite some time, but this is not likely to manifest until the last two quarters of 2018 or early 2019.”
In the meantime, two sectors to look out for are Oil & Gas and Retail, said Mr. Basu. “Tax reforms in the US may also have some effect on M&A activity, although details are as yet unclear. Therefore those developments are also worth watching,” he added.