S&P Global Ratings' European Structured Finance Conference in London on Sept. 5, 2024, attracted a record number of more than 420 attendees, a 40% increase compared with 2023. The prevailing sentiment at the event was one of optimism, fueled by solid issuance growth and resilience in the face of performance pressures.

Structured Finance Is In A Sweet Spot

Interest rates have peaked, inflation has normalized, and yields are returning to historical levels. If it wasn't for geopolitical uncertainties and trade tensions, European structured finance would be seeing virtually ideal conditions--a view that was reflected by both panelists and the audience at the conference's opening panel.

CLOs and RMBS have been the main beneficiaries of improving conditions, with both asset classes recording significant issuance growth, compared with 2023. That said, volumes have risen across the board, including the asset-backed securities (ABS) sector.

In terms of credit performance, the CMBS sector continues to experience the most significant stress. The recent value declines in the European retail real estate sector materially exceeded the peak-to-trough drop seen during the global financial crisis, while the slow wind-down of working-from-home arrangements only provided cold comfort to the office sector.

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ABS Sector Soldiers On

Most panel and audience members expect that ABS issuance volumes, which are already booming, will extend their streak. Panelists agreed that the slight deterioration in ABS credit performance over the past 18 months constitutes a normalization, after a period of exceedingly benign conditions. Affirmations and upgrades accounted for most rating actions year to date.

ABS benefits from low unemployment rates in Europe and supportive structural features, including tight triggers and the relatively short average life of transactions. Additionally, most consumers continue to prioritize paying off debt--a trend that started during the COVID-19 pandemic and hasn't reversed since.

Risk exposure in auto ABS transactions will remain lopsided, with battery electric vehicles most exposed to residual value risk. That said, a potential decline in demand for internal combustion engine vehicles could eventually constitute an inflection point that would see residual value risk shift away from electric vehicles. Government subsidies could play a key role in this transition.

Non-traditional collateral--including data centers, solar, salary sacrifice auto schemes, and "buy now, pay later" financing--could become more prominent in the ABS market over the long term. For now, however, scarcity and regulatory restrictions prevent a more significant pick-up.

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All The Stars Are Currently Aligned For CLOs

At our CLO session, panelists agreed that falling liability spreads, active third-party equity investors, and a workable supply of underlying assets have supported this year's boom in new issuance volumes. Interest across the capital structure appears to be robust, and the recent launch of the first euro CLO ETF is another positive demand-side development. Refinancing and reset activity has also picked up in the second half of this year, as spreads have returned to historical averages, giving managers more comfort to lock in new funding terms.

So what could derail the CLO train? Asset supply is likely the biggest risk. Recent reliance on amortization and the secondary loan market cannot continue forever, suggesting that, without a more substantial recovery in M&A activity, CLO managers could start to struggle constructing portfolios with functioning economics.

S&P Global Ratings expects the default rate in the wider universe of European speculative-grade corporates will peak at about 4.25% by mid-2025, which would be lower than during the COVID-19 pandemic. One panelist suggested that corporate defaults could be decorrelating, with different sectors going through widely divergent levels of stress. This could shift the focus toward credit selection and away from broader considerations of where we are in the cycle.

Light At The End Of The Tunnel For CMBS

According to panelists, there are signs that value declines are moderating across all commercial real estate (CRE) sectors. More forward-looking surveys of investor sentiment also herald improvement, and recently subdued activity means there are close to record levels of "dry powder" in CRE globally.

The U.K. market could recover faster than the rest of Europe. This is partly because value corrections materialized more quickly but also due to the better political stability from having recently installed a new government. By comparison, France and Germany, for example, are in political limbo, according to one panelist.

Logistics remains the most favored CRE sector. Data centers also attract high capital inflows. Investor interest in the office sector is polarized and strongly dependent on the nature of the tenants and the quality of the building.

One panelist was wary of investments whose future value recovery would mainly result from yield contraction, which could easily be derailed by wider macro and geopolitical risks. He argued that sectors such as last-mile logistics could be more resilient in such a scenario.

Although loan refinancing prospects have suffered from rising rates, lower valuations, and tighter lending standards, cash rental income has stabilized. In general, there have been few loan enforcements and only one of the loans backing CMBS that we rate is in special servicing.

Boring Isn't Bad In U.K. RMBS

Or as one panelist put it: "If nothing's changed in U.K. RMBS, I'm happy." Despite some headlines to the contrary, the asset class held up well over the past nine months and steered clear of major turbulence.

This has mainly been due to low unemployment rates, tight affordability regulations, consumers' considerable--albeit hard to quantify--savings buffers, wage growth, and forbearance measures, with lenders engaging early if borrower stress arises. U.K. RMBS has also benefited from consumers' prudence and prioritization of mortgage payments. Most borrowers fixed their mortgages for three years or longer when a rise in interest rates became increasingly likely.

Given the recent path of borrowing costs, long-term fixed-rate mortgages could come to the fore, enabling borrowers to lock in rates for longer than the current typical limit of five years. Panelists are also keeping an eye on the emergence of hybrid products, such as combinations of repayment and interest-only mortgages or interest-only mortgages with an equity release plan. Even though these products aren't particularly popular yet, partly because advice is thin on the ground, they are garnering increasing attention.

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Writer: Kathrin Schindler.