There will be two default phases. The immediate one is being driven by cash liquidity at companies that were struggling before the coronavirus pandemic. The second default wave will strike with no clear catalyst. It will hit companies that do not get back to 2019 ebitda levels, making debt burdens unsustainable.

2.0 CLO structures have higher subordination below each rating band and over-collateralisation tests have higher cushions versus 1.0 CLOs. Most CLOs have a 12% senior OC cushion and even with rating downgrades at twice current levels, plus triple Cs trading at 50-60 cents on average, it is hard to trigger a senior OC test without defaults.

This was an issue following the financial crisis. CLOs offer managers some flexibility and you have to look out for issuers that do not follow the tests as they are written. Managers that do not focus too much on the next equity cashflow, but take a long term view, will be rewarded when they next issue a CLO.

This entails diverting equity cashflows back to the CLO to help cure test breeches. It solves one of the problems associated with cure contributions — where is the cash going to come from? A regular cure contribution might need an equity investor to gain approval from its investors, which can take time.