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January 2023 | Issue 251

Are we ready for another crisis?

Sam Robinson
Data editor
Charlie Dinning
Data journalist
Credit managers must brace themselves for stress in 2023, as rates rise and the number of poor performing assets increases. But most CLOs look well-placed and can rely on plump OC cushions
With a global recession looming, and default rates and downgrades expected to rise in the coming year, the market is wondering whether CLOs can withstand another crisis.
Creditflux data shows that although weighted average prices are at 92.65 in the US and 89.48 in Europe, CLOs have plenty of breathing room, with US deals boasting average over-collateralisation cushions of 436 basis points, and European deals showing 438bp OC buffers. However, not all vintages are similarly well positioned.
In the US, 2018 CLOs are a clear outlier. Not only do they have average headroom of 300bp, they also have the highest average warf of any vintage. This crop of CLOs benefited from cheap financing, but has been hit by the covid shock in 2020 and by market volatility in 2022.
Of the 2018 contingent, 90.6% that are within reinvestment are set to leave it by the end of 2023. CLOs from this vintage could struggle to refinance, given 2018’s exceptionally tight spread levels.
2018 US CLOs: percentage of assets under 80 vs junior OC headroom
2018 US clos.svg
Source: CLO-i
Turning static is a drag
With a large volume of CLOs exiting their reinvestment periods in 2023, the performance of deals outside reinvestment has been a key consideration. These CLOs have poorer metrics than their fully-managed counterparts, with 104bp of junior OC cushion on average and 9.6% annualised returns to equity in Q3 in the US.
However, Tapan Jain, a portfolio manager at Hildene Capital Management, says these figures are not necessarily representative of opportunities in short-dated deals. “With deals long outside their reinvestment period, there is a measure of selection bias distorting the figures to the negative side, as these are deals where the refinancing or call options were not exercised.”
“There are lots of moving parts in single Bs”
Tapan Jain, Portfolio manager | Hildene
A variety of metrics are available to CLO investors evaluating reinvesting deals, but debt investors continue to rely on warf as an indicator of a deal’s performance, and to restrain overly enthusiastic managers. Warf figures are higher (ie, portfolios are riskier) in Europe than the US, particularly in older vintages. In Europe, warf is 2,961 for 2015 CLOs and 2,951 for pre-2015 deals.
For equity investors, warf is a murkier indicator of risk in a deal’s portfolio, as some managers can barbell their portfolio with extremely risky and high-rated assets.
“The number of assets below 80 increased”
Shawn Lim, VP, structured credit team | Vibrant Capital Partners
One clear indicator of tail risk in a CLO portfolio is assets marked below 80. Shawn Lim, vice president on the structured credit team at Vibrant Capital Partners, says: “Whilst over the course of 2022 there were various rallies in the loan market, the percentage of assets below 80 remained relatively unaffected, and otherwise steadily increased across the year.”
This demonstrates that high-quality assets benefited from rallies and poor performing assets represent a tangible risk in CLO portfolios, says Lim.
As it stands, in the US, 2017 CLOs have the largest proportion of assets marked below 80 (on average 7.91% of portfolios). In Europe, these assets make up 14.34% of 2015 deals. This figure was around 0.3% at the beginning of the year in Europe.
One of the headline metrics recently has been the amount of low B assets in CLO portfolios, which has hit record highs. Although on a macro-scale this might indicate a cause for concern, Hildene’s Jain argues that not all low single Bs are created equal. “There are lots of moving parts when looking at these assets,” he says. “Rather than just looking at the rating of the asset, you need to consider the industry, how it’s impacted by inflation, and what free cashflow and ebitda look like.”
Rate mismatch complicates matters
One significant macro-environmental factor impacting CLOs in 2022 is the volatile high-interest rate environment in the US, where a mismatch of one-month and three-month benchmarks between assets and liabilities dragged on equity returns, causing reinvesting US CLOs to return an average 13.50% in Q3, down from 16.53% in Q2.
One European manager argues that this effect has not been as pronounced in Europe, with CLO managers actually receiving some benefits from assets benchmarked to six-month Euribor. This is backed by the figures: European CLOs returned an average of 15.62% in Q3.
Despite these warning signs, CLOs look remarkably robust compared to previous crises. For example, unlike 2020, only a tiny number of CLOs are breaching OC tests. Vibrant’s Lim predicts that, on average, cushions are still sufficient to withstand forecast default rates of 3.5-4%.
After a record year in the secondary market — and with managers lining up new deals — clearly there is value in CLOs.
  • Data is taken from the most recently available trustee reports. CLOs without a report published for October or later were excluded.
  • Tables include data for CLOs within reinvestment period as of 31 November 2022. US CLOs excludes high triple C CLOs, mid-market CLOs, “turbo” CLOs and CBOs.
  • Assets were classified as triple C if the asset was rated Caa/CCC+ or below by either Moody’s or S&P, or by Fitch where they were the only rating agency. Assets were classified as single B on the same basis if they were not already classified as triple C.
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Global credit funds & CLO's
January 2023 | Issue 251
Published in London & New York.
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