In the Central Bank’s stab this week at estimating the fees shared by Irish lawyers, accountants, bankers and corporate service firms from special purpose vehicles (SPVs) in Dublin’s international financial hub, one type of exotic fund stood out.
So-called collateralised loan obligation vehicles (CLOs), containing repackaged loans of highly indebted companies with low credit ratings, the corporate world’s answer to sub-prime mortgages, dished out about €200 million in fees to Irish firms last year. They accounted for more than a fifth of the total generated by Irish SPVs.
The value of loan investments in the unregulated area of Irish-based CLOs has soared from €15 billion over the past seven years to €216 billion as of the end of March, turning Dublin into, by far, the biggest base for ultra-tax-efficient funds housing the riskiest type of company debt in Europe.
The trend was turbocharged two years ago when tax authorities in the Netherlands, previously another big CLO hub, slapped a 21 per cent VAT rate on managers of such funds. Ireland provided a safe harbour.
The market for leveraged loans defied expectations of a blow-up during the Covid-19 crisis as central banks and governments rushed to funnel trillions of euro into financial markets and the economy to avert Armageddon. This averted a spike in corporates reneging on their debt.
Indeed, the sheer volume of money pumped into the system would go on to fuel a global record of $1.1 trillion (€1 billion) of private equity deals last year — fuelled by loading the target companies with bank debt, much of which was largely subsequently sold on to CLO funds. European CLOs issued €38.5 billion of bonds last year, a post-global financial crisis record and up 75 per cent on the year.
CLOs, mainly put tighter by US- and UK-based asset managers, are cousins of a big cause of the 2008 financial crisis, collateralised debt obligations (CDOs), which were used to repackage pools of US sub-prime mortgages and refinance them in the international bond markets through a process called securitisation. In the case of CLOs, however, the borrowers are not households but companies.
The companies usually have very high levels of borrowings, typically tied to acquisitions, and carry junk credit ratings. However, CLO managers buy bundles of these corporate loans from banks and private equity firms and, with a tidy bit of financial alchemy, repackage most of them into AAA-rated bonds to attract even the most cautious of pension managers. (CLO vehicles also have lower-rated bonds that carry higher interest rates for investors willing to take the risk.)
But while CDOs were exposed at the end of the day to one asset — property — CLOs are invested in the debt of companies across a wide variety of sectors. European CLOs defaulted at a rate of 0.11 per cent in 2020, the height of the Covid-19 crisis, marginally below their long-term default rate of 0.13 per cent, according to S&P.
The market for the packaging of loans in CLOs and selling them on to investors has slowed dramatically so far this year, as private equity deal-making has slowed down amid rising market interest rates, the war in Ukraine and fears of a global recession.
Still, investor enthusiasm for bonds issued by CLOs has been buttressed by the fact that their interest rates — unlike those of corporate bonds, which are fixed — move up in line with market borrowing costs.
The relative attraction is obvious at a time when market rates are rising, as investors price in 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, has declined by 1.8 per cent so far this year. A similar index for riskier, low-rated CLO bonds has fallen 4.7 per cent. By comparison, a benchmark for corporate junk bonds, the S&P US Dollar Global High Yield Corporate Bond Index, has slid by 10 per cent.
Meanwhile, the S&P 500 index for US shares has dropped more than 16 per cent, while European stocks have fallen almost 13 per cent so far this year.
But the risks facing the least creditworthy corporate borrowers are growing.
On Thursday the European Central Bank hiked its euro-zone inflation forecast for this year to 6.8 per cent from a 5.1 per cent prediction made just three months ago. It sees the drag of higher food and energy prices on the economy — stoked by the war in Ukraine and ongoing lockdowns in China — resulting in gross domestic product growth slowing to 2.8 per cent from a prior estimate of 3.7 per cent.
The latest forecasts also factor in a recent spike in market interest rates. Hawkish noises from the ECB following its governing council meeting this week have left investors betting it will raise its deposit rate from minus 0.5 per cent to more than 0.9 per cent by the end of this year.
World Bank president David Malpass warned on Tuesday that for many countries “recession will be hard to avoid”.
With low growth and high inflation — or stagflation — remaining the order of the day next year, Europe’s highest-indebted companies are at the coalface.
Worryingly, a Central Bank report on CLOs published before the pandemic showed that protective covenants tied to leveraged loans in such vehicles had become gradually weaker at the same time as Dublin’s involvement in the market was growing.
An ECB paper last month noted that more than half of the €165 billion of leveraged loans written by European banks since 2019 — and largely sold on to CLOs — were, according to the jargon, “cov-lite”, or “covenant lite”. In other words, they had fewer borrower restrictions and weaker lender protections than standard loans.
Only a tiny percentage of loans in CLOs in Dublin are linked to Irish corporate borrowers, so the prospect of one blowing up would have little to no direct domestic effect. And the main concern would be around contagion rather than a bunch of investors losing money in one fund.
Fitch, the ratings agency, said in a report this week that the credit quality of European CLOs that it assesses “has remained relatively stable since the beginning of 2022″ and suggested that even in the event of prolonged and severe stagflation, the risks to CLOs are limited.
Then again, ratings firms held a similarly benign view of sub-prime mortgage CDOs at one stage, too.