CLOs could withstand another 13.4% of downgrades to triple C if the price drops to 50

Thomas Majewski

Founder & managing partner Eagle Point Credit Management

CLOs are well positioned, even if there are mass downgrades to triple C

The concentration of single B rated loans within CLO portfolios is increasingly in focus for investors. With memories from 2020 still fresh, many investors are concerned for what a wave of triple C downgrades could mean for CLO equity cashflows.

A CLO’s indenture is structured such that, if triple C concentrations and losses rise above certain thresholds and over-collateralisation test cushions deteriorate, quarterly cashflows otherwise destined for equity investors may be rerouted to support or amortise a CLO’s debt tranches. But in our view, concerns about equity cashflows being cut off in the near term seem exaggerated. They do not fully consider the size of current OC cushions and how skilled CLO collateral managers are able to trade to build par.

The percentage of the US loan market rated B-/B3 is at an all-time high — but only 4% of the loan market is triple C-rated. This is far less than half of where it stood during the height of covid — and the triple C concentration in the average CLO is about 20% less than market norms.

Today, the ratio of upgrades to downgrades of loans is roughly flat, though perhaps trending negatively. During September, there were only three more loans downgraded than upgraded. So although occasional defaults have begun pulling the market default rate off its historically low levels, the rate remains below 1% and should not prompt major concerns.

CLOs are in a good place

The 3.3% average triple C concentration in CLO portfolios today is back at pre-pandemic levels and is down nearly two percentage points from the same time last year. Today’s triple C levels are significantly below the 7.5% triple C buffer in most overcollateralisation tests. In addition, overcollateralisation cushions are back to near pre-pandemic levels of 4.6% for reinvesting CLOs.

Notably, this value is 50 basis points higher than the same time last year, owing to par building and more cushion in the most recently issued CLOs. Holding everything else constant, with a 4.6% OC cushion and a 3.3% current triple C concentration, the average CLO could withstand another 13.4% of downgrades to triple C if the average price of triple Cs drops to 50. That’s assuming more than half of the current B-/B3 loans are downgraded to triple C at once, which we see as improbable.

Opportunity in volatility

Against potential future credit stress, experienced investors understand that volatile markets provide par building opportunities and the ability for active CLO collateral managers to outperform. Throughout our discussions with dozens of CLO collateral managers, a theme of qualitative improvement and par building comes through nearly unanimously. Active traders have been able to take advantage of market fluctuations to pare risk, build par and diversify opportunistically.

Furthermore, the prepayment rate for October is still 0.8% — well below long-term averages, but still annualised to roughly 10%. Prepayments return par dollars that, within the closed system of a CLO, can be reinvested into discounted secondary loans. Active CLO collateral managers have also used market rallies to reduce their B-/B3 rated loan exposures. Unlike during 2020 covid-related volatility, we do not expect broad sector or industry decline or downgrades arising from systemic risk. Instead, idiosyncratic credit volatility should favour active CLO management and generally keep triple C levels well below the highs we saw during the pandemic.

As the market transitions into a period where downgrades become the new norm, the ability of CLO collateral managers to trade the underlying collateral will be an essential lever to maximise long-term equity returns within CLOs. Having CLOs within their reinvestment periods today is as valuable as ever.

Although investors are afraid of the risk of high triple C buckets, it is our view that there are sufficient mitigating factors in place to withstand a wave of downgrades for most CLOs. As long as investors remain diligent with respect to CLO collateral manager selection and reinvestment period runway, CLO equity cashflows will likely thrive as they benefit from reinvesting today using financing locked in yesterday.

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Global credit funds & CLO's

November 2022 | Issue 250

Published in London & New York.