We believe that CLOs’ underlying assets (leveraged loans) are likely to experience elevated downgrades and defaults as the economy realizes the impacts of the COVID-19 shutdown. Because of those downgrades and defaults, the CLO market is likely to be challenged. We expect a large number of tranches to be downgraded, a significant increase in the number of deals being shut off from receiving interest, that some lower mezzanine tranches will not return their full par value, and that most equity returns will be lower than marketed.
What is a CLO?
CLOs are actively managed, diversified pools of leveraged loans that have been securitized and divided into tranches with different orders of principal payment and different amounts of interest due. For a tranche to take a principal loss, the tranches below it must be completely wiped out. Additionally, the deals have tests and triggers that redirect cash flows from the lower tranches to the higher tranches in times of stress. These features combined with the manager’s ability to actively manage the pool of loans have helped CLOs weather adverse market conditions in the past.
Loan Market Defaults and Downgrades
We believe this time may be different. The loan market grew significantly over the past ten years, and the CLO market grew with it. Much of the growth in the loan market came from smaller and lower-rated companies. In fact, B2 and lower-rated companies stood at 49.7% before the markets were considering risks from COVID-19. The exhibits on the next page illustrate the trend toward lower quality in the loan market.
Elevated leverage and substantially looser underwriting in the run up to the current crisis has created a more vulnerable corporate borrowing base than in past cycles. Therefore, it is no surprise that defaults have been picking up and downgrades in loans have been significant and will likely continue. With CLOs making up 65%-75% of the loan market, they are likely to be impacted.
CLO Triggers and Tests
CLOs include a number of features (tests and triggers) meant to provide structural protection to the higher-rated noteholders. A critical feature of CLOs is that these tests are measured against the par value of the underlying loans—meaning that the structures are not marked to market. If the percentage of CCC-rated collateral exceeds a certain threshold (usually 7.5%), the excess CCC amount is counted at its market value, lowering the excess collateral available. Actual defaults will lower the excess collateral as well. The sudden and large wave of downgrades since COVID-19 emerged overwhelmed the market, causing more than 100 CLOs to fail at least one of these tests, redirecting interest to pay down principal on more senior notes. Further increases in CCCs and/or an increase in defaults could cause more deals to fail triggers. Investors in lower mezzanine and equity tranches in deals that fail one or more tests will receive less cash flow over the short term. In some cases, this may be temporary as the deal “self-corrects,” but in other cases, it may be permanent. While market values for these subordinate tranches are currently depressed, they have rallied substantially from the lows and we believe valuations remain relatively optimistic considering the scope of the current crisis.
CLO Downgrades
With an increase in downgrades and defaults on the underlying assets and the elevated risk of CLOs failing tests, rating agencies have been placing many CLO tranches on downgrade watch. We expect the majority of tranches currently rated BBB and BB to be placed on downgrade watch, with many eventually getting downgraded. We believe this could create opportunities for investors with the ability to parse through the distress to find attractive securities.
Current Values
AAA: Currently trading in the 165-235DM (discount margin) context. These bonds are risk-remote and given that they are priced at a discount, they would benefit from triggers failing and paying down principal early.
AA: Currently trading in the 215-315DM context. AAs share the same triggers as AAAs and thus cannot be shut off from receiving interest. They are also risk-remote. With prices in the mid-$90s, the pull to par could drive total returns to beat the stated yield.
A: Currently trading in the 285-385DM context. Single As can have interest diverted away but it is not likely to occur except for the bottom decile of deals. We think downgrades will be limited to the bottom quartile of deals and therefore, we recommend buying better-than-average deals from better-than-average managers.
BBB: Currently trading in the 450-900DM range. We think that there is still value in the higher-quality managers and very clean deals, but we recognize that it is not as attractive today after the recent run up in prices. Given the elevated risk of downgrades, cash flow interruptions and potentially principal loss, we are avoiding deals with weaker metrics. We think the dispersion between good deals and bad deals will continue to grow. We estimate that more than 50% of the market will go on downgrade watch with more than 30% likely to be downgraded.
BB: Currently trading in the 950DM to 1600DM context. We consider the risk of downgrades and cash flow interruption to be high and are increasingly concerned about principal impairment. Therefore, we are extremely restrictive on what we are willing to buy and at what price.
Equity: While LIBOR rates below the floors for some of the CLO collateral and the ability to buy discounted collateral are benefits to the equity holder, elevated defaults and downgrades mean that interest payments are likely to be curtailed. Good managers with flexible documents that were well-positioned heading into the crisis should be able to drive significant value for their investors. We think there will be better entry points.
Conclusion
CLOs can provide a great way to access the floating-rate market but the structural leverage and complexities must be carefully analyzed. We expect continued pressure from downgrades and defaults as the impact of the COVID-19 shutdown ripples through the market. We anticipate significant opportunities will develop at various points in the capital structure as the situation evolves.
Disclosure
This material is provided for informational purposes only and should not be construed as investment advice. Any opinions or forecasts contained herein reflect the subjective judgments and assumptions of the author only, and do not necessarily reflect the views of Loomis, Sayles & Company, L.P. Investment recommendations may be inconsistent with these opinions. There is no assurance that developments will transpire as forecasted and actual results will be different. This information is subject to change at any time without notice.
This is not an offer of, or a solicitation of an offer for, any investment strategy or product. Any investment that has the possibility for profits also has the possibility of losses.
Market conditions are extremely fluid and change frequently.
Past market performance is no guarantee of future results.
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