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January 2023 | Issue 251
Analysis
CLOs
Not every CLO can be a winner
Sayed Kadiri
Editor
The CLO industry has undeniably performed well enough to justify the plaudits it receives.
But there will always be some unloved CLO tranches that slip into triple C territory
The CLO market has had an incredible ascent in the past decade, but there are always some CLOs left trailing. Some 136 CLO tranches carry a rating of triple C or below, according to Creditflux analysis, and all but two of these are US deals.
Right about now, some early 2.0 US CLOs should be reaching maturity. Of course, that rarely happens in the CLO world, when at some point after the reinvestment end-date a liquidation will be deemed the most economical course of action. The advent of CLO resets and reissues in the mid-2010s has also given CLOs a new lease of life. But for some deals this has only amounted to a stay of execution.
It’s fair to say CLO managers and equity investors have attempted to give some ailing deals a chance to get back on track. In our data set of US CLOs with at least one tranche rated Caa1/CCC+ or lower, 91 CLOs closed between 2012 and 2017, and of those 57 have been reset.
“Directly after the expiry of the reinvestment period is one of the most worrying days”
Dan Ko, Principal and portfolio manager | Eagle Point Credit Management
Still, the overall benefits of CLO resets will greatly outweigh shortcomings. The same might not be said for CLO reissues, which take resets a step further by wrapping a legacy portfolio in a new structure with the potential for newer documentation. CLO reissues have been sporadic and limited, and they have not had a good hit rate — of 66 CLOs reissued between 2018 and 2019, 18 (over 27%) have been downgraded to triple C.
Vulnerable single Bs
Dan Ko, principal and portfolio manager at Eagle Point Credit Management, points out that many of the US CLO tranches now rated triple C were originally rated single B. From the outset, the investment case for these debt tranches versus CLO equity was not compelling, he says.
“For single B CLO noteholders, directly after the expiry of the reinvestment period is one of the most worrying days,” says Ko. “At this point, the CLO equity tranche has typically received its invested capital back through distributions alone, and the debt tranches from double B upwards are well-protected. There is uncertainty on the outcome for single Bs.”
91
Number of CLOs in our data with triple C tranches
Although debt coupons for single B CLO tranches are high, investors are taking high beta risk. “These bonds can move around 10-20 points even in benign markets and the total return volatility is often greater than CLO equity,” says Ko.
Just 22 CLO tranches originally rated double B have dropped into triple C category, but two original triple Bs that have fallen to this level are Halcyon 2012-1 and 2013- 2. It is rare for CLO debt to drop into default.
S&P Global Ratings counts 11 US CLO tranches that have defaulted among 2.0 deals. It calculates the default rate for US CLO double Bs at 0.18% and single Bs at 2.12%. The rating agency has outlined six US CLO tranches that are likely to default: Catamaran 2014-2, Halcyon 2012-1, Halcyon 2013-1, Mountain View 2014-1 and two tranches from Hull Street CLO.
Not all doom and gloom
There are always likely to be hidden gems among the cluster of CLO notes that are downgraded to triple C.
Ko gives the example of a 2015 US CLO in which Eagle Point had invested in a majority of the equity tranche. The CLO’s single B tranche was downgraded to Caa1, but Eagle Point bought some of these bonds in the secondary market at a discounted price on the basis that the notes were undervalued. Ko says the triple C-rated CLO tranche paid off at par this year.
A popular trade in the years after the global financial crisis was to hunt for seemingly busted CLO debt tranches in deals that would be likely call candidates. Junior debt in such deals could be purchased in the secondary market at deeply distressed levels, only to pay off at par. Often, investors would attempt to buy the debt of CLOs in which they held a large amount of equity, giving them influence over the CLO’s liquidation trigger.
That trade is alive and well today, sources say. In fact, execution is easier given the growth in the secondary market in the past 10 years, and the fact that CLO equity investors can choose to refi and reset debt tranches and achieve the same outcome of being paid out on their debt at par.
Another positive for CLO investors is that the majority of triple C-rated CLO notes are part of structures that are performing, with 99 posting positive over-collateralisation cushions for their double B debt.
Barings 2014-I, for instance, has been out of reinvestment for four years (it has not been reset or refinanced) and it has a junior OC cushion of 23.19% for its double Bs. The CLO was among the raft of deals downgraded in 2020, but its class E notes bounced back with an upgrade from Caa3 to Caa1 in October 2021.
NewStar Exeter Fund has built the most par, however, with a junior OC cushion of 68.75%. Middle market CLOs and European CLOs tend to have higher par subordination levels and this has largely spared them from downgrades to triple C. The only other mid-market CLO in our data is Great Lakes 2014-1. This has also rebounded and has a junior OC buffer of 7.34%. The only European CLO — Richmond Park — has built a strong OC cushion of 6.81%.
One other European CLO has slumped to triple C, but this deal is an outlier. Alhambra CLO is a static deal which closed in November 2019. It invests in Spanish SME loans.
Prospering in a recession
On the face of it, a spike in loan downgrades to triple C and a pick-up in default rates in 2023 does not bode well for CLO performance. But Matt Layton, partner at Pearl Diver Capital, says CLOs with sufficient reinvestment capacity could generate some of the highest returns in years.
“The pressure on loan issuers will grow in the second half of 2023 as the maturity wall creeps into view. That will necessitate amend-to-extent transactions, which should provide a big boost to CLO weighted average spreads,” says London-based Layton.
“Amend-to-extent transactions should provide a big boost to CLO spreads”
Matt Layton, Partner | Pearl Diver Capital
He says a similar scenario played out in 2010 after the global financial crisis. But on this occasion the loan maturity wall is closer, with 2024 a big year. The June 2023 deadline for transition to Sofr is also a catalyst. “Demand for loans will remain high from new issue CLOs currently warehousing and re-investing,” he says. “Refinancing will therefore be much easier than during the global financial crisis when the CLO market completely shut down.”
23.2%
OC cushion of Barings 2014-I, which has been upgraded to Caa1
CLOs with triple C tranches
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Global credit funds & CLO's
January 2023 | Issue 251
Published in London & New York.
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