ESG considerations are increasingly a factor in the US CLO market, according to a recent report by Citi’s CLO strategist Maggie Wang. By 2023, Maggie sees 20-40% of US CLO managers incorporating ESG factors into new issues (versus 11% in 2020). As we highlight in this summary, however, greater ESG adoption might be capped by 1) a lack of ESG data at the corporate level, 2) loans with ESG-friendly terms being concentrated into a few sectors, and 3) a lack of industry standards for evaluating the ESG credentials of high-yield loans.
Securitization is becoming green, driven by two forces: 1) growing investor appetite for ESG-compliant products and 2) policy makers highlighting the need for responsible investment.
In 2019, 7 of 212 (3%) US new issue collateralized loan obligations (CLOs) across 7 managers included ESG factors. This number rose in 2020, to at least 20 of 188 CLOs across 15 managers. By 2023, Maggie expects that 20-40% of US CLO managers will include ESG considerations, representing $30bn in issuance.
However, multiple roadblocks could hinder this progress. One problem is the short supply of ESG loans. Green bonds currently account for just 0.25% of the Bloomberg Barclays High Yield index. Similarly, only 0.1% of the S&P/ Loan Syndications and Trading Association (LSTA) Leveraged Loan index is green loans.
Moreover, ESG-compliant loans are concentrated in a few sectors and regions: most loans are to utilities companies, and EMEA and APAC accounted for 88% of ESG linked issuances, with only 10% coming from the US (see Figures 1 and 2). ESG loans struggle to reach the diversification threshold for CLO managers. Further, most ESG-compliant loans are investment grade, and they have typically been used for capital expenditure and revolving tranches. These loans are usually sold to banks.
Figure 1. 2020 Global Green & ESG Loan Volume by Industry
Source: LSTA, Refinitiv LPC (LSTA, The Dawn of a New Era for ESG, n.d.).
Figure 2. 2020 Global Green & ESG Loan Volume by Region
Source: LSTA’s “The Dawn of a New Era for ESG” presentation, using Refinitiv LPC data.
Finally, private companies in the leveraged loan market are less equipped to communicate the operational information relevant to ESG targets. Some progress has been made on this with the LSTA ESG questionnaire, but Maggie notes that “the adoption rate for this questionnaire has been difficult to track, and an industry standard for evaluating issuers does not yet exist.”
Still, the number of green issuances is accelerating. ESG loan issuances have increased 15x in the last four years. Of the six green bonds in the Bloomberg Barclays High Yield index, half were priced in the second half of 2020, and both of the green loans in the S&P/LSTA index were priced in 2020. In Europe, 2021 has seen three sustainability-linked deals worth $5.3bn.
Rating agencies are attempting to remedy the lack of a standard definition for the ESG evaluation of loans and CLOs. Moody’s, for example, provided a set of general principles for composite ESG credit impact scores. In general, investors will need to track two factors to evaluate the ESG-compliance of CLOs:
a) Whether CLO managers’ underwriting processes use reliable and transparent data, and
b) Whether invested collateral demonstrates sustainability performance.
Negative screening is commonly applied by CLO managers to determine the ESG status of loans, to the exclusion of sectors deemed to be high risk. However, there is no consensus on what should be excluded. Some CLO managers will include sectors that would be excluded by others, such as coal or private prisons. This lack of an industry standard is another barrier to ESG progress in the CLO and leveraged loan market.
For more information on this subject, please see Global Structured Credit Focus - ESG: The Next Frontier for CLOs and Loans.
Citi Global Insights (CGI) is Citi’s premier non-independent thought leadership curation. It is not investment research. The comments expressed herein are summaries and/or views on selected thematic content from a Citi Research report. For the full CGI disclosure, click here.