Global credit funds & CLO's
May 2020 | Issue 223
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Flex CLOs tap mass downgrades to fill big triple C buckets
Michelle D'Souza headshot
Michelle D’Souza
Reporter
May 2020 | Issue 223
CLO managers are being hampered by the sheer volume of corporate credit downgrades to triple C, leaving the small cluster of triple C-flex CLOs to capitalise.
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This variety of CLO, which comes with a bucket of up to 50% for triple C names versus a 7.5% limitation on regular CLOs, was designed specifically to be in a position to buy triple C-rated loans when other CLOs become forced sellers of these assets.

Z Capital Credit Partners has two CLOs with 50% triple C buckets and has, until now, been using less than a third of this triple C capacity.

“We manage two of these deals, but we weren’t aggressive with that flexibility when we ramped the deals,” says Andrew Curtis, who leads the credit investment team at Z Capital.
“Managers are worried that today’s B3 is tomorrow’s triple C”
Andrew Curtis, Credit investment team lead | Z Capital
“Before covid-19, our deals had approximately 12-18% triple C assets. We thought we could take advantage of and leverage the deals’ significant investment flexibility in a period of dislocation.”

The majority of CLOs are expected to breach their triple C tests after Moody’s and S&P downgraded 160 credits into this rating band in March. This has affected $29.1 billion of US CLO credits and €2.3 billion of European CLO credits, as reported by Creditflux last month.

“In late February, following the SFIG conference, we came back and raised a lot of cash,” says Curtis. “Loans had not dislocated at that point. Today, we are running cash levels between the two deals of around 9-11%.” He says that Z Capital raised more cash than that, but reinvested some of it, buying high-quality loans that dislocated in March.

Once a traditional CLO breaches its triple C test, it is bound to maintain or improve its triple C standing, restricting a manager’s ability to buy these loans, and often incentivising triple C sales. A high triple C exposure also means a greater haircut on overcollateralisation scores, which could ultimately cause a CLO to shut off equity distributions.
According to Curtis, CLO managers are becoming reluctant to add even low single B loans to their portfolios. “They are worried that today’s B3 is tomorrow’s triple C, which is reasonable given the pace of downgrades,” he says, adding that Z Capital had looked at such loans in early April, but judged that they would be downgraded to triple C and price lower later, which is exactly what happened.

“We have the ability to buy more triple Cs, but we also have a greater capacity to withstand ratings migration in our existing portfolio compared to traditional CLOs,” Curtis adds.

Several firms are said to be launching funds focused on triple C loans discarded by CLOs. One manager of traditional CLOs is also looking to price its first triple C-flex deal.
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