A collateralized loan obligation (CLO) is a structured credit product that is collateralized by a pool of leveraged commercial loans comprised of senior-secured, first-lien, broadly syndicated loans made to companies with ratings below investment grade.
From the issuance of debt and equity, a CLO receives capital to acquire a diverse portfolio of senior secured bank loans. The debt issued by a CLO is split into separate tranches, securitized, and offered to investors. Each tranche has a different risk/return profile based on its priority of claim on the cash flow generated by the underlying pool of loans, which is paid to the investor in scheduled debt payments.
In a volatile market with fluctuating interest rates, CLOs have remained a high-performing investment vehicle—a trend we expect will continue in 2022.
Thanks to historically low interest rates and high inflation, the CLO market could well see an influx of cash in the near future. The EU securitisation market is already on course to break records in 2022, and it looks as though CLO investments will only continue to expand.
But there may well be wholesale movement in the market due to two recent events:
- New securitisation laws in Luxembourg
- EU AML blacklisting of the Cayman Islands
In this article, we’ll take a look at the most recent factors impacting CLO behaviour and offer our thoughts on where they’re going next.
Luxembourg is modernising its securitisation laws
On 9 February 2022, the Luxembourg parliament approved new legislation permitting securitisation vehicles to allow CLOs. The amendment to Luxembourg’s 2004 Securitisation Law lifts previous “passive management limitation” restrictions, which were aimed at protecting investors from assuming additional risk. By allowing the active management of acquired assets in the form of loans, Luxembourg can now offer an efficient framework for actively managed CLOs.
The new regime is designed to transform Luxembourg into an alternative jurisdiction of choice for CLOs. At present, Europe’s CLO activity centres on Dublin, but Luxembourg represents an intriguing (if still emerging) rival.
Competition between European jurisdictions should benefit CLO managers, who now have greater flexibility and more choice.
Cayman Islands added to EU AML blacklist
Meanwhile, Cayman faces a new hurdle as the European Commission’s Delegated Regulation (EU) 2022/229 entered into force on 13 March, placing the Cayman Islands (among several other jurisdictions) on the list of high-risk third countries with strategic AML/CFT deficiencies.
This has come as a consequence of the Financial Action Task Force (FATF) having added the Cayman Islands to its own list of “jurisdictions under increased monitoring” in February 2021. Cayman remained on the FATF’s monitoring list when it was updated in October, although a FATF enhanced follow-up report released in November confirmed Cayman as “Largely Compliant or Compliant” with all of the FATF’s 40 recommendations. The earliest opportunity to be removed from the FATF’s monitoring list will be in late 2022, with this acting typically as a precursor to removal from the EU blacklist.
One key implication is that, under the EU Securitisation Regulation (EUSR), securitisation special purpose entities (SSPEs) with an EU nexus may not be established in Cayman while it remains on the list. It is unclear whether divestment would be required where an EU investor already holds a securitisation positive in a Cayman SSPE, however liquidity is still immediately impacted as EU investors can no longer be buyers in the market for any Cayman-issued securities.
This is particularly relevant for U.S. CLOs seeking EU investors, most of which are issued using entities domiciled in the Cayman Islands. Managers of such CLOs will need to consider whether they can continue with current transactions involving Cayman SSPEs.
The future of CLOs
We are in the midst of a volatile period for global markets, with massive selloffs in tech stocks and government bonds. But strong performance across European securities saw this asset class outperform other areas of fixed income. CLOs in particular saw improving metrics in 2021, and the outlook for leveraged loan defaults continues to improve.
Amidst this volatility, high-yielding CLOs will likely do very well, though some of the lower-yield securities may flatten.
And it looks more and more as though Ireland and Luxembourg will be the two jurisdictions jostling for position as the domicile of choice—not only for CLOs, but for other investment vehicles as well.
IQ-EQ has over 20 years of experience in securitisation services
IQ-EQ’s credit team has been involved in servicing CLOs since the 1990s, focusing on the U.S. market and the European CLO bases, and expanding our solution in line with the needs of our clients. With localised expertise in key jurisdictions, we are well-equipped to handle anything from private or warehouse transactions to multi-tranche, multi-currency benchmarks.
To learn more about our CLO services, please click here or get in touch.