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Investors voice concern over Euro mezz spreads despite strong CLO performance
by Shant Fabricatorian
The numbers don’t lie — the spread contraction in European CLOs over the first half of 2024 showcases one of the market’s strongest performances in years. But that rapid tightening has brought concerns about whether current mezz pricing is accurately reflecting the credit environment.
Average spreads on triple B, double B and single B coupons have each tightened by at least 200 basis points since the end of last year, putting them near all-time tights. Triple B coupons, for instance, have narrowed from around 520bps above Euribor in the deals that printed last December to the current market level of around 300bps over Euribor, according to Creditflux data.
Support for current spread levels has been bolstered by strong investor demand and a buoyant August pipeline. But some investors say the pace of tightening downplays the risks of higher-for-longer rates and increased geopolitical hazards.
“We are still facing higher rates for a longer time. We’ve seen a few of the larger players have negative experiences or events,” said one European CLO investor. “So, while it’s been idiosyncratic, it’s an indication of things boiling beneath the surface.”
Interest rates have remained stickier than was anticipated earlier in the year. While the ECB cut rates by 25bps in June, core inflation figures for that month remained unchanged at 2.9%, indicating that further cuts may not come as rapidly as expected.
CLO mezz spreads are particularly sensitive to companies being stressed by higher interest rates, which makes them reactive to the prospect of rates remaining elevated. Apart from the well-publicised cases at Altice France, Intrum and Ardagh, there has also been an overall uptick in default rates, although these remain within projected levels.
Investment grade has been better supported
Simon Gold
Trader
Chenavari Investment Managers
In addition, investors are becoming increasingly concerned about emergent political hazards. There are the ongoing ructions within Germany’s ruling coalition, the uncertainty generated by France’s recent parliamentary elections and, in the US, the unpredictable curveball thrown by Kamala Harris’ ascension as the Democratic presidential nominee. Tensions are also increasing in the Middle East.
While none of these necessarily signifies a sweeping shift in policy direction or investor sentiment, all have engendered a different set of risk assessments on the part of the market, which sources said remains in flux for the time being.
According to Laila Kollmorgen, a portfolio manager at PineBridge Investments, the tension between these external risks and mezz spread tightening can be explained by strong underlying demand. “I agree that the tightening of European CLO spreads is not reflecting European recession or geopolitical risks,” she said. “At some point, bad economic news will translate into wider spreads. Currently, strong technical demand has kept spreads tighter than otherwise.”
The explanation of underlying technical strength was backed by Simon Gold, a trader at Chenavari Investment Managers: “I don’t think the pull back in mezz spreads is due to credit, but more mean reversion and a lack of momentum, having already significantly tightened.”
He added that while the retrenchment mainly affected triple B, double B and single B tranches, triple A, double A and single A-rated tranches have continued to tighten. “Investment grade has been better supported partly due to the pay-down of risk here, as deals begin to amortise, as well as the generally wide price of new issue relative to the tranches lower down the capital stack,” he said.
“Dispersion seems to be increasing between higher-quality managers/portfolios, and weaker ones,” added Serhan Secmen, head of the global CLO platform at Napier Park Global. “These wobbles will eventually translate into wider markets, [although the] timing is impossible to guess.”
For the moment, however, continued tightening seems to be the order of the day.
