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January 2021 | Issue 230
All’s well that ends well in 2020 OC tests
Charlie Dinning
Data journalist
Tanvi Gupta headshot
Tanvi Gupta
Head of data journalism
Sam Robinson
Head of data
Swathes of CLOs failed over-collateralisation tests last year, but unlike the drawn-out recovery following the 2008 financial crisis, the return to compliance after the covid-19 crash was rapid
The CLO market has recovered quickly from the coronavirus-induced sell-off, ensuing loan downgrades and over-collateralisation (OC) test breaches.
For the first time in a decade, CLO test breaches and resultant diminished equity cashflows were in the spotlight. The pandemic brought a worse crash than the 2008 financial crisis, yet the new issue CLO market bounced back inside three weeks (the period during which the primary CLO market closed in March and April), instead of the year it took after 2008.
The 2020 loan downgrade wave led to CLOs exceeding their typical 7.5% triple C-rated loan limitations, which meant CLO managers had to contend with an excess triple C haircut to their par balance. As triple C-rated loans bottomed out in price, this haircut increased and meant CLOs were losing par and tripping OC tests.
By May, 342 (35%) of US CLOs that were within their reinvestment periods were either under water or one point above the threshold for their junior-most OC test. The average junior OC cushion across reinvesting US CLOs fell to 1.69 points.
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Average junior OC cushion (bp)
Reinvesting US CLOs (%)
Source: CLO-i
CLOs given chance to build par
However, as Chandrajit Chakraborty, chief investment officer at Pearl Diver Capital in London points out, the loan price crash created opportunities for CLO managers to improve their collateral by trading for higher quality loans. “Loans were at such a deep discount that you were able to get the same or similar yield buying better quality loans, creating better net asset value and par in the portfolios. Because you are buying higher rated loans you are also better positioned for any future volatility.”
Chakraborty also points to the fact that CLOs have a self-correcting mechanism when failing an OC test, courtesy of the diversion of cashflows to pay down senior debt when a CLO fails its OC test.
Reinvesting CLOs recovered quickly thanks to managers trading efficiently and the leveraged loan market bouncing back. Out-of-reinvestment CLOs were entirely dependent on the market. By May, 51.9% of deleveraging US CLOs were failing their junior-most OC test, and this figure had decreased to 41.2% as of October reports.
“You could buy better quality loans”
Chandrajit Chakraborty, Chief investment officer | Pearl Diver Capital
CLO managers that were able to trade also benefited from triple C rated loans rallying in the secondary market and increasing their value. According to Bank of America’s weekly CLO research from 2 October, approximately $2.3 billion (net) loans held in CLOs were upgraded from triple C to single B in August and September.
By October reporting dates, only 213 US CLOs (21.8%) within their reinvestment periods were either failing or passing their junior-most OC test by less than a point. Of those CLOs, 164 were passing by less than a point; 19 were failing by less than a point.
However not all investors are happy when a deal is only just failing its junior-most OC test. According to one equity investor, failing an OC test by a small margin reflects badly on the manager because, if the result is going to be close to the trigger, the managers should find a way to pass.
* payment date followed this test result
* excluding 2019 deals
Loan liquidity held up in 2020
CIFC Asset Management was the largest of the 48 US CLO managers to not breach an OC test on any deals from March to October. Mark Sanofsky, managing director at CIFC states that loan liquidity gave managers the opportunity to reposition risk in their portfolios and, crucially, liquidity was much better in 2020 than in 2008.
“Many factors contributed to this improved liquidity, but a much lower overhang of forced sellers (including TRS market value CLOs), mark-to-market warehouses, and massive bank underwriting risk were the key drivers,” he says.
European and mid market CLOs had few failures as both have limited exposure to sectors hit hardest by covid-19, such as oil and gas. Mid market loans also have a higher proportion of loans with Libor floors compared to the broadly syndicated loan market, and those floors are higher, according to market sources. This means mid market CLO assets continued to pay at a good level even when Libor crashed.
“There were three key liquidity drivers”
Mark Sanofsky, Managing director | CIFC
No European CLOs within their reinvestment periods came into the crisis in March failing their junior-most OC test, and only eight deals breached an OC test between then and October. For those deals that did fail, there was a quick recovery: 2.2 months on average. Man GLG Euro II, a 2016 vintage CLO, had the quickest recovery, of just one month, between its June and July reporting dates.
Seasoned US CLOs were the most affected by covid-19 volatility: 47.0% of 2014 vintage deals that were still reinvesting were tripping their junior-most OC result in May. This was down to 16.7% by October. In contrast, only two 2019 vintage CLOs — Oaktree 2019-1 and 2019-2 — were still failing in October (from a high of six in May).
  • Data consists of all CLOs that were within their reinvestment period as of October 2020, and closed before 2020.
  • The junior-most OC test result was taken for each CLO between March and October reporting dates. If a CLO did not produce a report for a given month, the nearest available report was taken.
  • All data sourced from CLO-i and Moody’s Analytics.
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Global credit funds & CLO's
January 2021
| Issue 230
Published in London & New York.
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