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Europe's toxic corporate debt nudges CLO market towards new era

[LONDON] A growing list of European companies falling into distress as the economy slows is pushing the region's market in collateralised loan obligations (CLOs) towards a coming of age.

CLOs - bundles of loans to corporate borrowers that are repackaged and sold on as bonds rated according to their risk of default - have started to see a deterioration in the quality of the debt that goes into them.

The number of loans underlying European CLOs trading at a price of 80 per cent of face value or lower has risen by one percentage point from a post-crisis low of 0.4 per cent in April, according to research from Barclays plc.

That combined with concerns of cyclical downturn is prompting investors who buy the CLOs to raise questions about risk creeping into those portfolios. This could lead more CLOs into being priced based on the track record of who packaged the debt, a practice known as tiering.

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"With the increase in loan downgrades and more loan issuers becoming distressed, manager selection is becoming more relevant," said Geoff Horton, CLO strategist at Barclays. "I still don't think you see as much tiering as you should, at least in primary market, but I'd guess as we move along and more names become distressed, then that will change."

Tiering has already taken hold in the US market, which at US$642 billion is bigger than its US$108 billion European counterpart, according to data compiled by JPMorgan Chase & Co.

In the US there's a 15 basis-point gap on triple-A tranches between first and third tier managers, Nomura analyst Pratik Gupta said in emailed comments.

"It gets more pronounced at the bottom of the stack where double-Bs price around 700 basis-point area for top tier versus the low-to-mid 800s for less established managers," Mr Gupta said.

This increase in risk follows a benign credit environment in recent years. And while no manager is immune from dealing with their share of underperforming assets, the overall level of portfolio stress remains low and CLO performance is strong. To date there have been no defaults in post-crisis European CLOs.

But European CLO managers have recently lost money by selling out underperforming loans for Hilding Anders International AB and Survitec Group Ltd, according to people familiar with the transactions. CLOs are also significant holders of Lecta SA, whose floating rate notes due 2022 fell to a record low of 31.3 euro cents earlier this month, Bloomberg data shows.

Meanwhile, the pace of loan downgrades has picked up this year and number of distressed companies in the region rose in the first half for the first time in more than two years, according to a report by Moody's Investors Service.

Investors say that the list of names found in CLO portfolios that trade well below their face value is well into the double digits and in several instances includes defaulted assets from CMC di Ravenna SC and Galapagos Holding SA.

That means a more challenging environment for CLO managers and investors are likely to look more closely at their track record, according to Alexander Ohl, portfolio manager at Union Investment.

"We will once again see managers with bad past performance only be able to price deals at very wide tranche spreads," he said.

BLOOMBERG