European leveraged finance: A bifurcated balancing act: CLOs: New pockets of sustainable growth

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  • European collateralised loan obligation (CLO) new-issue volume reached €30.1 billion in 2019
  • This was 11 per cent above the €27.2 billion netted over the previous year
  • The fourth quarter of 2019 saw €8 billion in CLO issuance

Demand for CLO exposure among investors grew in 2019, driven by a decade of low interest rates and cash, treasuries and corporate bonds offering minimal yield.

Data from Creditflux confirms the CLO's ongoing popularity: New issue volume achieved a post-crisis record, reaching €30.1 billion in 2019. This was 11 per cent up on the €27.2 billion in 2018 and more than double the €14.3 billion in new CLO issuance seen in 2014.

However, the benefits of the CLO model have the potential to extend well beyond delivering yields for pension funds and institutions.

The bond market—and CLOs in particular—have the reach and access to liquidity to raise the US$100 trillion the UN believes will be required to deliver its Sustainable Development Goals (SDGs) by 2030.

CLOs and SDGs

The formation of sustainable CLO markets may be one of the best ways to fund environmental and other SDG projects at the pace required to confront climate change and to deliver the SDGs by 2030.

11%

The percentage rise in new issue CLO volume in 2019, up from the year before

Banks alone will not be able to provide the necessary volume of sustainable lending. But fund managers can turn sustainable loans into tradeable, liquid CLO securities. While some broadly syndicated loan (BSL) CLOs have criteria that exclude investments based on sustainable environmental, social and governance (ESG) standards, these could be turned into 'SDG-positive' structures.

Such SDG-positive BSL structures will soon begin to appear in the market, while other types of SDG CLOs with different types of loan collateral are also in the works and expected in 2020—for example, SDG-aligned infrastructure loans, including clean-energy CLOs.

Ratings firms are already prepared to rate SDG infrastructure CLOs, and banks are planning both true sale and synthetic structures. This asset class is expected to develop in 2020 alongside SDG-positive BSL CLOs and SDG sovereign bonds.

 

Forward momentum

The market's coalescence around SDGs as the standard on which the sustainability of a CLO is judged is a game-changer for these new structures. The SDGs enable borrowers to enter into sustainability-linked loans and bonds.

Under sustainability-linked loans, borrowers could be penalised if they fail to deliver on the SDGs to which they had committed and incentivised with lower front-end coupons.

At the moment, there are not enough leveraged loans linked to SDGs, which means CLOs cannot realistically include minimum SDG benchmarks. Instead, SDGpositive CLOs will include economic incentives that will be triggered once the level has been ramped up with sufficient sustainable assets.

There could also be modification provisions, such as covenants designed to maintain minimum levels, and that would help SDG CLOs qualify as European Central Bank repo collateral in due course.

Investors in CLOs are already working with CLO managers to find ways to incorporate ESG elements into their decision-making when constructing leveraged loan portfolios. For example, ESG-focused Hermes Investment Management is reportedly having discussions with CLO managers to find out how they are engaging with ESG issues and to find ways for loans to improve those efforts.

Managers point to the lack of ESG-linked information provided by borrowers as an obstacle to deciding who has genuine SDG credentials. But with the introduction of SDG benchmarks and standards, nothing stands in the way of SDG CLOs' expansion.

We cannot wait for the regulators and central bankers to catch up; we need to get to work now.

[View source.]

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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