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January 2024 | Issue 260
Analysis
CLOs
How worried should we be about defaults?
Poh-Heng Tan
As defaults in the US loan market continue to stack up, we investigate the fallout for CLO investors by focusing on the OC tests of double B tranches across 10 years of US CLO vintages
The chart below displays the latest average OC test cushions at the BB-rated level for broadly syndicated loan (BSL) CLOs as of 1 December 2023, segmented by vintage year, highlighting the 25th, median and 75th percentiles.
Factors such as excess CCC buckets, defaults, discount obligations and credit losses from trading can all negatively impact the OC ratio. Generally, OC test cushions tend to decrease as deals mature during their reinvestment period. This is because the underlying collateral pool of a US CLO, which is typically rated at B1/B2, suggests a cumulative default rate of 16.1%-20.7% over five years, according to Moody’s idealized cumulative expected default rate table.
Average current OC test cushions for US BB tranches
As of 1-Dec-2023, source: Intex, CLO Research
Risk of principal impairment
However, a more pressing concern is the loss given default (LGD). For instance, a BB-rated CLO tranche can withstand a cumulative default rate of up to 20.7%. But if the LGD exceeds 50% — particularly when combined with trading losses — this can result in principal impairment. Although principal impairment at the BB level remains relatively minimal, the default rates for original BB-rated CLO tranches are likely to increase, especially since more than 25 deals already show OC ratios (BB) below the 100% level.
Unsurprisingly, the median 2014 vintage deal has the poorest OC test cushion, underscoring the challenges of that vintage. In 2014, the US CLO market witnessed record issuance, followed by significant volatility in the loan market in 2015 and early 2016. Many 2014 deals were significantly impacted by their exposure to the oil and gas, commodity and utility sectors.
1.6pp
Tiny OC test cushion of median 2018 deal indicates erosion of principal
Let’s examine a potential default candidate more closely. This particular BB-rated US CLO tranche from the 2014 vintage is likely to experience principal impairment. A primary reason is the notably low recovery rates of defaulted oil and gas assets. As this deal is now nearly a decade old, it has experienced a cumulative default rate of 17% based on the original collateral balance.
While the annual default rate might appear manageable, at less than 2% per annum, the central issue with this deal lies in its low weighted average recovery rates (approximately 42%) as per market prices reported in trustee reports concurrent with the defaults.
As anticipated, the substantial LGD has severely impacted the deal’s OC ratio. Notably, its OC (BB) test has been breached since July 2019 and has not recovered, even during the amortization phase. Additionally, the excess CCC/Caa adjustment contributed to further reducing the OC ratio, particularly in 2020. Credit losses from trading are expected to further exacerbate the final loss rate of the BB tranche as the residual portfolio is eventually liquidated.
Metric changes since inception
Table 2 shows the OC (BB) test cushions, segmented by vintage year, at inception. Examining the median metrics at inception for vintages from 2012 to 2018, they ranged between 4.04 and 4.50 percentage points. In comparison, their latest median metrics ranged from 0.65 to 2.20 percentage points — significantly lower than those at inception.
On the other hand, as indicated in table 1, some US CLO deals have increased their OC test cushions since inception. Notably, the 75th percentile deals issued in 2020 and 2022 have seen improvements. Many redeemed deals from these vintages also achieved impressive equity IRRs, benefiting from negative collateral loss rates thanks to the ‘pull to par’ effect. Apart from deals that have bought portfolios at a discounted price, the deleveraging of performing deals can also lead to improvements in OC ratios.
Both tables source: Intex, CLO Research Table 1: as of 1-Dec-2023
Excluding 2012 deals (due to their low sample deal count), the 2013 vintage has the next weakest test cushion. This is to be expected, given that these deals have been outstanding for an extended period.
Notably, the median 2018 vintage deal has a concerning test cushion of only approximately 1.6 percentage points, indicating a sizable erosion of principal value. This is likely to negatively impact final equity IRRs.
While deals from the 2018 vintage had some of the best outcomes in terms of CLO liability pricing, it is crucial to recognize that favourable liability pricing does not always correlate with strong underlying asset performance. In other words, the corresponding tight levels of asset pricing do not necessarily mean better asset performance.
The final IRR of a 2.0 CLO equity tranche depends heavily on the realization of the final equity net asset value (NAV). In a typical arbitrage CLO deal, a final NAV of over 50% is usually sought to provide CLO equity investors with a double-digit IRR. Moreover, it is important for annual distributions to reach at least 15% over a period of approximately five years. That being said, if a deal can consistently yield an annual distribution of approximately 14% for a duration of 10 years or more, it will exhibit diminished reliance on the eventual equity NAV realization to achieve a low-teens IRR.
Downsides of record issuance
Another observation that one can derive from table 1 is that it appears that whenever there is a year of record issuance, such as 2014 or 2018, asset performance is somewhat affected, at least based on the median OC test cushion metrics.
On the other hand, the median deals from 2019 to 2022 have a much healthier level of OC (BB) test cushion. While 2021 vintage deals still show a good level of OC test cushion, it may be too early to determine their final performance. That year saw record primary CLO issuance and lax credit conditions.
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Global credit funds & CLO's
January 2024 | Issue 260
Published in London & New York.
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