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May 2023 | Issue 254

Stress ticks up in CLOs as downgrades take triple C loans to over 5% of market

Hugh Minch
Senior Reporter
The percentage of the leveraged loan market rated triple C passed 5% in April and further expected downgrades are likely to push the figure over 7.5% in the coming months.
This is a sign of the economic headwinds that came to a head with the banking sector volatility in March. As questions continue to swirl around the likely timing of a recession, CLO managers are grappling with what they see as a dispersion of possible outcomes for the asset class.
Speaking at IMN’s Investors Conference on CLOs and Leveraged Loans in New York in April, PGIM’s Edwin Wilches said the number of triple C-rated loans could rise to 15% of the market if a third of the B3-rated loans get downgraded.
“I don’t know what the numbers will end up being, but between 15% and 20% of portfolios are going to be distressed,” Wilches said. He added that managers with distressed debt investment divisions are likely to over-perform when it comes to recovery rates.
“Between 15% and 20% of portfolios are going to be distressed”
Edwin Wilches, MD and co-head of fixed income securitised products | PGIM
The CLO market absorbed a wave of downgrades in late 2022 and negative rating actions have trickled in since then, reaching their highest since 2020. Back in April that year, amid the onset of the covid-19 pandemic, around 60% of CLOs breached their triple C tests and 13 failed junior over-collateralisation tests. Of reinvesting CLOs, 7% missed an equity payment as a result.
Market participants point to the active management of CLOs as the best weapon against rising credit stress, and metrics show CLO managers hold fewer triple C-rated loans than the market as a whole. At time of press, just 5% of US CLOs are breaching the 7.5% triple C limit with S&P. Only 3% are in breach with Moody’s. However, recovery rates in default scenarios are likely to be lower than was seen in past downturns, according to Lauren Basmadjian, co-head of liquid credit and head of US loans and structured credit at Carlyle Group.
“This cycle is going to feel very different for CLOs because of where the base rate is,” she said at the IMN event. “The ability to put debt back in a company is going to be lower, which means less debt reinstated for CLOs, which means less par coverage and more OC deterioration when something does default.”
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Global credit funds & CLO's
May 2023 | Issue 254
Published in London & New York.
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