When times are good, optimistic investors often respond to sceptics who say it can’t last with the phrase, “this time is different”. But given the explosive growth since the global financial crisis in the market for low-quality leveraged loans and collateralised loan obligations, this time really could be different – and not for the better.
The $800 billion market for CLOs – asset-backed securities that contain a portfolio of leveraged loans – “is under severe stress”, and the probability of large total loan defaults “has risen significantly” under current market conditions, according to a report last week by MSCI titled “Could coronavirus lead to default contagion in CLOs?”
The sell-off in the leveraged loan market significantly widened spreads, which have “surpassed peak levels during the global financial crisis”, the report continued. Prices for leveraged loans plunged 13 percent in the first quarter, with the benchmark S&P/LSTA US Leveraged Loan 100 index at 83 cents on the dollar as of 2 April, according to Bloomberg.
Moreover, unlike the global financial crisis, the abrupt economic shutdown caused by the coronavirus has led to “dramatically increased” default correlations between sectors, the report said. In the space of a few weeks, a measure of cross-sector default correlation soared to higher than 80 percent from below 30 percent, potentially reducing CLOs’ traditional diversification benefits, MSCI said.
CLO losses “in the region of $100 billion” over the next two years are expected by Alberto Thomas, founding partner of economics firm Fideres. In a memorandum, Fideres projected the default rate on CLOs to jump to 15 percent in 2020 and 10.5 percent next year, with lower recovery rates than in the past because of the high percentage of “covenant lite” loans included in CLOs, and the higher leverage among borrowers.
Lender protections in more recent issues of the underlying leveraged loans have significantly declined since the financial crisis, with loan terms more akin to those of high-yield bonds than traditional bank loans, Fideres said. Although these types of riskier loans were rarely issued prior to the financial crisis, their share of issuance has jumped to nearly 80 percent of new loans, it said.
Consequently, Fideres forecasts recovery rates in CLOs of between 40 and 50 percent, significantly lower than the historical rates closer to 80 percent. In the absence of government bailouts to leveraged loan borrowers, Fideres expects defaults in US and European CLOs of between $94 billion and $106 billion over this year and next. Based on its analysis, losses on CLO tranches will mostly affect hedge funds and mutual funds.
“The leveraged loan market is going through a lot of pain,” said Greg Obenshain, partner and director of credit at Verdad Advisers, a Seattle hedge fund. “Default rates will be very high,” he added, noting that the S&P/LSTA index fell nearly 20 percent in March alone. As for the CLO market, he said it “tends to be dominated by a few large players”, among them Apollo, KKR and Blackstone Group.
The most recent Shared National Credit Report from the Office of the Comptroller of the Currency (OCC) showed that 94 percent of non-banks’ leveraged lending commitments (inclusive of term and revolvers) were rated non-investment grade versus 41 percent at banks as of Q3 2019, according to Fitch Ratings. The OCC defines non-banks as primarily including CLOs, loan funds, investment managers, insurance companies and pension funds.
But Fitch noted that although non-bank market participants may face greater exposure than US and foreign banks in a sustained downturn, the increased interconnectivity of the financial system means a downturn that impacts the various non-bank entities could also cascade to the banking sector.
In its December report titled “Vulnerabilities associated with leveraged loans and CLOs”, the Financial Stability Board said that although redemptions from non-bank funds had not caused liquidity strains in these markets to date, their exposures could “nonetheless add to the risk of procyclical behaviour in times of stress”.
The FSB added that stress episodes could have negative implications for insurers, pension funds and other non-banks with CLO exposure, and that structurally higher non-financial corporate leverage “can amplify financial markets shocks”.
Indeed, S&P late last month lowered ratings on 15 CLOs, placing stressed sectors on CreditWatch negative. As of March 20, 27 percent of the exposure across S&P’s CLO Insights 2020 Index carried, on average, a negative outlook or were on CreditWatch negative.
The amount of CLOs outstanding has doubled from pre-financial crisis levels, the Bank of England said in its July 2019 Financial Stability Report. Around two-thirds of global CLOs are held by non-bank investors, who typically hold the riskier tranches, the BOE said. It estimated that international banks, particularly US and Japanese institutions, hold the remainder. The report identified the largest holders of CLOs as US and other global banks, with $160 billion, and insurers, with a like amount of exposure. Japanese banks hold $96 billion, while European banks hold $32 billion, the BOE said. Some $128 billion of CLOs are “unallocated”, meaning their holding is unaccounted for.
Although the BOE noted that CLO structures today are “more robust” and financed by “more stable sources” than the securitisation market for subprime mortgages during the financial crisis, “the recent deterioration in lending standards means that losses on CLOs would probably be higher” than 2008 in any stress scenario.
Last July, it estimated that loss rates of representative CLOs issued in 2006 were at 9 percent the day of the financial crisis, and that for representative CLOs the rate could increase to 14 percent for securities issued in 2018. But that report didn’t anticipate a global coronavirus pandemic and the economic destruction it would wreak.