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January 5, 2023updated 06 Jan 2023 11:03am

How green are collateralised loan obligations?

Increasing demands for ESG disclosures means investors are looking in detail at the pool of assets within CLOs.

By Adrian Murdoch

CLOs, collateralised loan obligation, ESG score
  • At the beginning of November, 73% of European CLOs had a neutral ESG rating.
  • While European CLOs have relatively high social and governance scores, they fall down on their environmental figures.
  • Investors are increasingly expected to demand more granular details of the pool of assets in which they are investing.

Collateralised loan obligations (CLOs) don’t often make the news (at least, not for the right reasons). A single security backed by a pool of loans, CLOs are generally dismissed as niche financial products.

But for investors, the ESG ratings of CLOs are likely to become more important as they look for details of what it is in a portfolio.

Although only small correlations between ESG scores and asset performance are seen in the current market, for the third quarter of the year, secondary market spreads rose 128% to 736 basis points (bp) for the underlying assets held in CLOs with lower ESG scores while those with top scores rose only 56% to 690bp.

A report published at the end of November by Fitch Ratings, ‘What Investors Want to Know: ESG Scores in Fitch-Rated European CLO Portfolios’ is the first to shine a sustainable light on the asset class. It rated 89.7% of the notional amount of the portfolio of Fitch-rated European CLOs.

“What we wanted to address for the CLO investor was to give them the opportunity to be able to cross-compare every single portfolio that they invest in, and then suddenly they can start making decisions based on that,” Richard Jefferies, global head of ESG scores for leveraged finance at Sustainable Fitch in London, tells Capital Monitor.

Where this kind of analysis will come into its own is with sustainability-linked loans. “It’s an interesting space that is developing,” says Jefferies.

An increasing proportion of Europe’s loan market has ESG margin ratchets tied to the interest rate of the loan that has a step up or step down depending on whether the borrower has hit some or any of the key performance indicators.

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This will only make ratings on loan portfolios even more important.

Mostly neutral ESG scores

On 7 November 2022, almost three quarters (73%) of European CLOs had a neutral ESG score, indicating “no direct positive or negative impact on ESG”.

No assets held in Fitch-rated European CLOs have ESG Scores in either the lowest or the highest category.

“What we have in the market,” says Vincent Scalvenzi, senior director for structured finance at Fitch Ratings in London, “is quite a lot of concentration in terms of issuer compared to the US market”.

A typical CLO, he continues, has around 160 issuers and the overlap between CLO portfolios is pretty high – around 60%.

“A lot of managers have the same assets in the portfolio,” he says, pointing out that the European leveraged loan market at the moment has only around 500 issuers.

But when digging into the assets, it becomes clear that while European CLOs have relatively high social, and governance scores, they fall down slightly on their environmental figures. More than a third (35%) and 27.3% of CLOS were in the second highest categories for social and governance, while almost a third (31.5%) were in the second lowest category for environmental.

The reason for the lower environmental scores, says Scalvenzi is because of the sectors that make up European CLOs.

High-emitting sectors like gaming and leisure, chemicals, building and materials, and industry make up almost a quarter (21.9%) of CLOs while it describes pharmaceuticals and healthcare providers (10.2%) as “over-represented” in the second highest environmental category.

“The pharmaceutical industry got a pretty high score in terms of social, but pretty low in terms of environment,” confirms Scalvenzi.

There is little differentiation to be seen in country performance, the report says. “Fitch-rated European CLOs are typically well diversified across countries…the ESG Scores distribution is mainly driven by the industry.”

“The corporates that are in the CLOs do business in a lot of different countries,” says Scalvenzi, pointing out that a UK company may still do a lot of business in Germany, France and Spain. “That makes it more difficult to see a correlation between ESG and country.”

CLOs: Under the hood

The issue of CLOs is one that investors are going to be looking at in ever more detail.

From next year, within Europe, for example, fund managers will have to report on Scope 3 emissions – indirect emissions that occur in a company’s value or supply chain – within their portfolios, according to the Sustainable Finance Disclosure Regulation (SFDR).

The direction of travel for increased disclosure across all areas of finance is clear.

“If you start having CLO managers begin to say that they are not going to invest in any deal with a certain environmental score, then that could move that could start the market,” says Jefferies.

The same is true from an investor's point of view, and this is where Jefferies thinks that the push could come from. It is not hard to imagine a situation, he says, where investors could say that they want a certain minimum score and a certain average score in a portfolio.

He sees this as positive for the market. When both managers and investors look in increasing detail beneath the hood of what is in a CLO then this, he says creates positive change.

“We’re looking for companies to become more environmentally and socially sustainable,” he concludes.

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