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August 2022 | Issue 248
Analysis
CLOs
We can cope with downgrades again
Tanvi Gupta
Head of data journalism
Charlie Dinning
Data journalist
Sam Robinson
Head of research
Having overcome one loan downgrade wave in 2020, the CLO market is now facing another. But this time CLOs are defensively positioned, and managers have a chance to adjust portfolios
CLO portfolios are under pressure with loan downgrades looming — particularly to triple C. If that sounds familiar, it’s because the CLO industry went through this sort of phase only two years ago.
This time though, the downgrade wave will be different. For starters, CLO managers are better positioned. US CLOs have an average triple C bucket of 4.17%, whereas European CLOs have 3.92% exposure across the three vintages in our dataset.
Vintage plays a huge role in the health of a CLO portfolio, as deals are likely to deteriorate with age. 2018 US CLOs have an average triple C bucket of 5.15%, versus 4.56% in Europe, while the 2019 vintage CLO average is 4.37% for US CLOs and 3.84% for European CLOs.
US CLOs typically have a higher triple C exposure than their European counterparts. But for 2020 vintage CLOs, triple C buckets are higher in Europe on average, at 3.27% versus 2.69% for US CLOs.
US CLOs: triple C vs B3/B- exposure (%)
2018-2020 vintage CLOs Source: CLO-i
Going on the defensive
Although the stats look good, CLO equity investors have raised concerns, especially, as downgrades have overtaken upgrades. “We don’t have concerns about the over-collateralisation test but we want managers to be defensively positioned as we go to war against inflation,” says a New York-based CLO investor.
A London-based CLO manager says his firm is taking a cautious approach with its triple C bucket, despite being below average in terms of exposure. He reasons that rating agencies in the past downgraded on the basis of liquidity issues, but seem now to be downgrading because they’re under pressure to resolve names that have been on negative outlook for a long time.
4.17%
Average triple C bucket for US CLOs in our data set
In the US, AB has no exposure to triple C assets from our dataset, while Pimco’s is close to zero. Sound Point Capital Management and Axa Investment Managers are the two best placed managers in Europe.
Downgrades to triple C tend to be idiosyncratic, says David Gillmor, S&P’s sector lead for European leveraged finance. “The dynamic for us is to understand the limitations of the companies’ flexibility to absorb rising rates, particularly in the B- universe. Are they all going to stay there? No. But on a macro basis, we do not expect to see the macro environments changing to such levels that you’ll have large scale movements.” He adds: “Recession is not our base case.”
Research published by Moody’s on 20 July presents a murky scenario if interest rates continue to increase. “If rates rise 300 basis points, almost half of B3s would have interest coverage fall to 0.98x and negative free cashflows and absent earnings growth,” it says.
“There are all types of financial engineering available to PE”
Christina Padgett, Managing director | Moody’s
Moody’s distressed B3N list of B3 negative and lower issuers had grown to 171 entries in June, making up 10.7% of the total US speculative grade population. While default rates are still low, at 1.4% in the US, companies on the list have a high chance of default if credit conditions deteriorate.
Moody’s senior analyst Julia Chursin says PE-owned companies make up two-thirds of the B3N list, with nearly 80% of such companies having been downgraded to it in Q2. “These companies tend to gravitate towards loans-only debt structures for the most part. In a downturn, this does not bode well for investor recoveries in default scenarios,” she says.
2018-2020 vintage CLOs Source: CLO-i
*Latest trustee reports available for these managers were published after 16 June, which saw considerable loan market depreciation, and which may have affected WAP, <80% and <90% figures.
2018-2020 vintage CLOs Source: CLO-i
*Latest trustee reports available for these managers were published after 16 June, which saw considerable loan market depreciation, and which may have affected WAP, <80% and <90% figures.
Private equity firms will act
Christina Padgett, managing director at Moody’s, believes private equity firms are aggressive investors which will need to protect their investments because, even if the economy isn’t going into recession, it’s quite possible that the valuations they envisioned for their credits have weakened.
“What will they do to address that? Will there be a distressed exchange, some acquisitions at low prices using debt that is senior to existing debt? There are all types of financial engineering available to PE, especially given the deterioration in credit protections within loan agreements.”
“It’s helpful to swap credit risk into duration risk using the 5% bond bucket”
Lauren Basmadjian, Head of US loans and structured credit | Carlyle Group
The slow expansion of the low single B universe in the past two years has been boosted by many new loans being rated at this level, particularly from tech and software companies. Moody’s Padgett adds that, over time, the rating distribution changed. B3 became more popular than B2 as debt service became affordable and the bank market, where PE sources most of its funding, expanded. B3s now comprise about 30% of the North American market.
“Borrowers are coming to lenders 12-18 months ahead of scheduled maturity for a refi”
Sandeep Chana, Director in Emea structured credit | S&P
Another area of concern is maturity weighted average life. Sandeep Chana, director in Emea structured credit at S&P, says a lot of debt is maturing at the end of 2024. “Typically, if borrowers do a refi, they are coming to their lenders beforehand, for example 12-18 months ahead of scheduled maturity. If there’s no refi, you may go down the ATE [amend to extend] route, which was common during the financial crisis. There is a lot of history coming back,” he says.
2018-2020 vintage CLOs Source: CLO-i
*Latest trustee reports available for these managers were published after 16 June, which saw considerable loan market depreciation, and which may have affected WAP, <80% and <90% figures.
CLOs face a slow bleed
Despite the outlook being unclear, CLO market participants agree the pace of downgrades is expected to be much slower than the rush two years ago.
S&P’s Gillmor says the rationale is different this time. “The 2020 downgrade wave was all about the unexpected liquidity shock and how well positioned the single B credits were to deal with liquidity constraints and cash facilities. Today a key question is how robust the business is going to be for a material increase in cost for a substantial length of time.”
A New York-based CLO manager says recent downgrades are a bit more company specific.
“With a much slower pace of downgrades, CLO managers will have the ability to swap assets and control portfolios, unlike in 2020, which froze everything,” says the CLO PM.
Effects specific to the pandemic linger, especially for those business that really thrived then but are now experiencing slower growth because people are putting their dollars elsewhere.
Lauren Basmadjian, head of US loans and structured credit at Carlyle Group, says Carlyle is looking at firms with a covid bump to see if they will continue to perform if that bump goes away. “We often used 2019 as base profitability for credits with potential covid bumps. That could prove to be too generous, as so much demand was pulled forward during covid, and 2022/2023 could look worse for some companies than 2019.”
European CLOs: triple C vs B3/B- exposure (%)
2018-2020 vintage CLOs Source: CLO-i
Shed your triple Cs now
Many CLO managers have been cleaning up their triple C buckets as the volume of single B loans grows along with fears of sustained period of downgrades, says a European CLO manager.
A US CLO manager adds: “You can exit lower rated assets without hurting par.” He says the key difference between now and 2020 is that loan prices are not currently low, but dispersion between loans and bonds is greater, so you can rotate credit without burning par. “You have the opportunity to swap a triple C loan of 70/80 with a double B secured bond in the 80s.”
Carlyle’s Basmadjian says it’s worth moving to duration risk. “In a rising rate environment, some fixed rate bonds could be arb negative, but over 95% of your assets are positive arb even if every bond you buy isn’t. It’s helpful to swap credit risk into duration risk using the 5% bond bucket.”
Another European CLO manager says cleaning out triple C buckets might leave a minor dent in some cases, but par levels are strong enough for it not to matter. This was backed by a global equity investor, who says if a CLO has a 3% cushion, it is comfortable to burn par in order to sell a credit that has a risk of default.
Methodology
- Triple C bucket figures have been calculated by taking the highest result from either triple C concentration limitation test.
- Loans classified as B3 or B- mean that any rating agency with a corresponding triple C bucket on the deal has rated the loan as B3 or B-, but not Caa1/CCC+ or lower.
- Any loan that is purely privately rated, or has withdrawn ratings, has not been considered for the purposes of calculating B3/B- exposure.
- Equity and assets without market value data have been excluded from weighted average price calculations.
- All figures have been taken from June 2022 reports. If a June report is not available, the nearest available report has been taken instead.
- All 2018, 2019 and 2020 vintage CLOs are included, apart from high triple C flex CLOs and CLOs with triple C buckets calculated at time of purchase. This includes reissues of deals that originally closed between 2018 and 2020, and excludes reissues of deals that originally closed before 2018.
- CBOs and mid-market CLOs are excluded.
- Data is sourced from CLO-i and Moody’s Analytics.
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Global credit funds & CLO's
August 2022 | Issue 248
Published in London & New York.
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