In the Central Bank’s attempt this week to estimate the fees shared by Irish lawyers, accountants, bankers and business services firms from special purpose vehicles (SPVs) in Dublin’s international financial centre, a type of exotic fund s is marked out.
So-called Secured Loan Obligation (CLO) vehicles, containing repackaged loans from highly indebted companies with low credit ratings, the business world’s answer to subprime mortgages, have disbursed around 200 million euros in fees to Irish companies last year. They accounted for more than a fifth of the total generated by Irish SPVs.
The value of lending investments in the unregulated area of Ireland-based CLOs has risen from €15 billion over the past seven years to €216 billion at the end of March, making Dublin, by far , the largest base of ultra-tax-performing funds housing Europe’s riskiest corporate debt.
The trend was accelerated two years ago when tax authorities in the Netherlands, previously another major CLO hub, imposed a 21% VAT rate on managers of these funds. Ireland provided a safe port.
The leveraged loan market defied expectations of an explosion during the Covid-19 crisis as central banks and governments scrambled to funnel trillions of euros into financial markets and the economy to avoid Armageddon. This has prevented an increase in the number of companies forgoing their debt.
Indeed, the sheer volume of money injected into the system would fuel a world record $1.1 trillion (€1 billion) in private equity deals last year – fueled by charging target companies with bank debt, much of which was subsequently largely resold to CLO funds. European CLOs issued 38.5 billion euros of bonds last year, a record after the global financial crisis and a rise of 75% over the year.
CLOs, primarily tightened by US and UK-based asset managers, are cousins to a big cause of the 2008 financial crisis, asset-backed bonds (CDOs), which have been used to repackage pools of US subprime mortgages and refinance them into international bond markets through a process called securitization. In the case of CLOs, however, the borrowers are not households but businesses.
Companies typically have very high levels of borrowing, usually related to acquisitions, and have questionable credit ratings. However, CLO managers buy batches of these corporate loans from banks and private equity firms and, with a bit of financial alchemy, repackage most of them into AAA-rated bonds to entice even managers. the most prudent retirement plans. (CLO vehicles also have lower-rated bonds that carry higher interest rates for investors willing to take the risk.)
But whereas CDOs were ultimately exposed to a single asset – real estate – CLOs are invested in the debt of companies in a wide variety of sectors. European CLOs defaulted at a rate of 0.11% in 2020, at the height of the Covid-19 crisis, slightly below their long-term default rate of 0.13%, according to S&P.
The market for packaging loans into CLOs and selling them to investors has slowed significantly so far this year as private equity deals have slowed amid rising market interest rates, war in Ukraine and fears of a global recession.
Yet investor enthusiasm for bonds issued by CLOs has been bolstered by the fact that their interest rates – unlike those on corporate bonds, which are fixed – rise in line with market borrowing costs. .
The relative attractiveness is evident at a time when market rates are rising, as investors bank on central bank hikes to combat soaring inflation globally.
An investment market index that tracks the performance of AAA-rated CLO bonds, the Janus Henderson AAA CLO ETF, is down 1.8% so far this year. A similar index for riskier, lower-rated CLO bonds fell 4.7%. By comparison, a benchmark for junk corporate bonds, the S&P US Dollar Global High Yield Corporate Bond Index, fell 10%.
Meanwhile, the S&P 500 index of US stocks has fallen more than 16%, while European stocks have fallen nearly 13% so far this year.
But the risks faced by less creditworthy borrowers are increasing.
On Thursday, the European Central Bank raised its inflation forecast for the euro zone for this year to 6.8%, from 5.1% just three months ago. He sees the effect of rising food and energy prices on the economy – fueled by the war in Ukraine and ongoing lockdowns in China – causing gross domestic product growth to slow to 2, 8% compared to a previous estimate of 3.7%.
The latest forecast also takes into account a recent spike in market interest rates. Hawkish noises from the ECB following its Governing Council meeting this week left investors betting it would raise its deposit rate from minus 0.5% to over 0.9% by the end of the week. end of this year.
World Bank President David Malpass warned on Tuesday that for many countries, “recession will be hard to avoid.”
With weak growth and high inflation – or stagflation – set to remain the order of the day into next year, Europe’s most indebted companies are at the forefront.
Worryingly, a Central Bank report on CLOs published before the pandemic showed that the protection clauses attached to leveraged loans in these vehicles had gradually weakened along with Dublin’s involvement in the market. was increasing.
An ECB article last month noted that more than half of the 165 billion euros in leveraged loans taken out by European banks since 2019 – and largely sold to CLOs – were, in the jargon, “cov -lite” or “covenant lite”. . In other words, they had fewer borrower restrictions and weaker lender protection than standard loans.
Only a tiny percentage of loans in CLOs in Dublin are tied to Irish borrowers, so the prospect of a boom would have little or no direct effect on the domestic market. And the main concern would be contagion rather than a group of investors losing money in a single fund.
Fitch, the rating agency, said in a report this week that the credit quality of the European CLOs it rates “has remained relatively stable since the start of 2022” and suggested that even in the face of prolonged and severe stagflation , the risks for CLOs are limited.
Then again, rating agencies had an equally benign view of subprime mortgage CDOs at one point as well.