The days of easy money are over, and it’s anybody’s guess when they will return. Although the $1 trillion market for collateralised loan obligations has a track record of performing well through credit cycles, including the global financial crisis, a confluence of stresses that weren’t present during the last big liquidity crunch could well make this time different.
In the run-up to the subprime mortgage debacle that triggered the GFC, the mantra was: “a rolling loan gathers no loss”. Everyone knows what happened when the music stopped and there was no one to buy the paper or refinance the debt. In this cycle, participants throughout the credit markets are on edge, trying to jockey for position amid slowing economies, rising interest rates, stubbornly high inflation, a looming energy crisis in Europe and the war in Ukraine.
“Everyone is trying to find out what the fallacy is that we all should be aware of,” says Serhan Secmen, senior managing director and portfolio manager at Napier Park Global Capital. He posits that it could be that inflation will prove more difficult to tame than anticipated.
Although visibility is somewhat clouded, there is little doubt about how we got here: the injection into the financial system of huge amounts of monetary morphine by the US Federal Reserve and other central banks artificially suppressed interest rates over an extended period. At the same time, US and European credit markets have tripled to more than $5 trillion since the GFC. The leveraged loan market – the same loans that provide the underlying collateral to CLOs – has more than doubled, to $2 trillion, even as loan quality has deteriorated and covenants have loosened.
“What we have today is the largest asset bubble in history,” asserts Dan Zwirn, founder and chief executive officer of Arena Investors. Zwirn and two Johns Hopkins finance professors predicted the gathering storm back in 2019, in a paper entitled This Time Is Different, But It Will End The Same Way. The paper outlines how unrecognised secular changes in the bond market since the 2008 crisis may precipitate the next one.
Zwirn isn’t alone. Elliott Management, one of the world’s most influential hedge funds, told investors in its third-quarter letter that what it had been anticipating for some time is now here: “The other side of the bubble mountain.” It said a hard landing in the global economy appears “quite likely”, and a deep recession, while substantially reducing inflation, “could also be a dangerous development in a vastly over-leveraged global financial system, causing significant credit issues”.
Elliott named leveraged holders of mortgage-backed securities, structured debt products and CLOs – which could be facing “substantial markdowns” – among the areas where stress could create accelerants and transmitters of high risk and significant further asset price declines. One of its conclusions: “Investing and trading in the coming period is likely to be as difficult as we have ever encountered.”
Whereas risk during the GFC was highly concentrated among a relatively few institutions – primarily banks – the cumulative effect of mispriced risk is much larger now, as is the debt outstanding. Moreover, in 2008, interest rates were falling, not rising as they are now, and the Fed was in a much stronger position to manage through a crisis.
The Fed itself recently expressed concerns that “funding risks expose the financial system to the possibility that investors will rapidly withdraw their funds from a particular institution or sector, creating strains across markets or institutions”. It also said that bank lending to non-bank financial institutions – which can indicate the latter’s leverage and their interconnectedness with the rest of the financial system – reached a new high of nearly $2 trillion in the second quarter of 2022.
Easy credit conditions helped fuel a M&A explosion, including private equity-sponsored buyouts, which are often financed by leveraged loans, also known as brodly syndicated loans. Nearly 70 percent of leveraged loans – typically senior secured, below investment grade debt instruments – end up being securitised and packaged into BSL CLOs. Mid-market CLOs, issued by the originator of the loans, comprise about 10 percent of the overall market.
CLOs are actively managed as funds that contain a hierarchy of risk-based debt tranches, as well as a small portion of equity. Both CLO debt and leveraged loans are floating-rate instruments that are rated and pegged to a benchmark such as LIBOR. Most CLOs are called arbitrage CLOs because they aim to capture the excess spread between the portfolio of leveraged bank loans, or assets, and the classes of CLO debt, or liabilities, with equity investors receiving any excess cashflows after the debt investors are paid in full.
Record low interest rates created “a starvation for yield that fed into a huge appetite for people buying CLO equity at a fraction of the appropriate price and that was, most importantly, out of alignment with CLO managers who have no skin in the game”, Zwirn says.
But Zwirn maintains that it isn’t just the buyers of CLO equity and lower-rated debt whose interests aren’t aligned with the managers. Other misalignments in the ecosystem include CLO managers who provided inexpensive and overly permissive leveraged loans to PE sponsor/borrowers, who in turn had raised capital from limited partners and paid record multiples for leveraged buyouts with high-multiple, floating-rate debt that will now be difficult to refinance and will make delivering appropriate equity returns “extraordinarily challenging”, he says. When things start to unravel, as they likely will, “the people on the wrong end of the trade are going to get hurt”.
A grim preview of what could lie ahead was the rout in the UK gilt market in October, which led to pension funds scrambling to sell their AAA CLO debt to cover margin calls. Although CLO managers are quick to reassure that they are never forced sellers, the sale of top-tier CLO debt demonstrated that in a liquidity crisis, investors in a hurry often unload their higher-quality assets.
“As the world thinks we’re heading closer and closer to a credit downturn, those with ratings-based investment criteria who are worried about downgrades will be under selling pressure,” says Bret Leas, partner and head of asset-backed finance at Apollo. “We’re seeing a lot of private debt come up for sale in the credit secondaries market.”
Deep-pocketed asset managers stand ready to pick up highly rated assets on the cheap, as Apollo did when it took $1.1 billion of the UK pension funds’ $1.5 billion of AAA-rated CLO debt off their hands in the October selling frenzy. Co-president Scott Kleinman said on the firm’s earnings call that Apollo’s purchases were made at an effective 8 percent yield, relatively high for the safest CLO debt.
“We’ve already seen valuations this year drop across the board in the CLO debt market,” says Pratik Gupta, a CLO analyst at Bank of America, noting spreads on CLO AAA debt doubling to 220 basis points over LIBOR since the start of the year. But it is not the top of the CLO capital stack causing the most concern.
“AAA and AA CLO tranches have never lost money, even during the GFC,” says Apollo’s Leas.
Says Jason Friedman, partner and global head of business development at Marathon Asset Management: “As long as you are a hold-to-maturity investor in AAAs, you’ll be okay.”
On the other hand, CLO equity returns have been -15 percent as of the end of September, Gupta says. “The question is, to what extent have you priced in the stress scenario?” Participants most at risk, he says, are managers at the margins and borrowers. Moody’s, in a GFC stress scenario it applied to a sample of the CLOs it rates, found that average CLO default exposure in the US spikes to 12.3 percent and in Europe to 13 percent, from the current 0.3 percent and 0.2 percent, respectively.
Nevertheless, the CLO market today is “nowhere near as pessimistic as it was in 2016”, when BBs fell below 70 cents on the dollar, says Dave Preston, head of structured credit research at AGL Credit Management. Today they trade in the low 80s on the secondary market.
Markets have been relatively orderly thus far, says Jerry Ouderkirk, head of structured credit at Pretium Partners. But “there’s a tremendous premium on credit selection, and market dislocation and higher volatility will expand the opportunity set”, he says. “Lower priced assets are going to go a lot lower.”
Although the floating-rate nature of CLO debt is often touted as a benefit relative to high-yield bonds, that can cut two ways, especially when interest rates are rising in a slowing economy.
“CLO holders of existing liabilities should feel increasingly uncomfortable because the coverage ratios of the underlying loans are dramatically worse,” says Ivan Zinn, founding partner and CIO of Atalaya Capital Management. “Companies are barely able to cover their interest costs now.”
A stress test in October by credit rating agency KBRA of 1,900 non-investment-grade companies it evaluates found that anticipated interest rate increases alone would result in as many as 16 percent of mid-market borrowers in its universe failing to generate enough cashflow from operations to cover their interest expenses.
“It’s going to be a challenge for companies if they don’t have current cashflows to meet obligations,” says Secmen of Napier Park. But he adds that he’s heard from multiple sources that as much as interest coverage will be challenged, “we believe most issuers are well set, with a lot of free cashflow”.
Yet a recent white paper by Marathon notes that the average-debt-to-EBITDA ratio for new loan issuances surged to 5.5 times in 2022, with more than one third of the loans issued since 2021 levered to six times or higher. Those numbers may be significantly higher, Marathon says, because the leverage ratios are calculated on “pro forma” earning projections.
Moreover, many loans outstanding were issued by new borrowers who were held to easier credit standards and who never experienced a credit crisis. According to the Marathon paper, first-time issuers represented “a staggering” 50 percent of loan issuance in 2019, much higher than the average of 37 percent from 2010 through 2017. “These first-time issuers will certainly be tested as the economy enters recession,” according to Marathon.
So too will some CLO managers, especially those who have never gone through a credit cycle. That could lead to market consolidation, given that top-tier managers are already commanding tighter spreads from their investors than their lower-tier competitors, according to PitchBook LCD. Nearly 90 percent of the leveraged loan market is “covenant-lite” and many also have additional baskets and looser restrictions around collateral – meaning that protections for existing lenders are weak. By giving these loopholes to borrowers, it’s a “perfect environment” for lenders with lots of capital to step in, says Marathon’s Friedman. He says there is already “lender on lender violence” going on, with some charging they have been stripped of their collateral.
“The first sign of trouble will be a wave of downgrades from BBB or B-minus to CCC,” says Secmen. According to the Marathon paper, a significant percentage of companies rated BBB will have inadequate liquidity, with some 60 percent of the BBB-rated corporate borrowers susceptible to downgrades. If those companies’ ratings are downgraded just one notch to CCC, that could cause additional selling pressure given the holding constraints of CLOs.
Defaults may surge
Although Moody’s baseline forecast for leveraged loan defaults in 2023 is 4.4 percent, it projects that, under tougher conditions, default rates could surge to 7.8 percent in the US and 6.5 percent in Europe by August 2023.
But defaults may not have to reach a peak to upset the market. “Fear of defaults, as opposed to actual weakness in the portfolios, can cause people to run for the exits,” says Apollo’s Leas. “Price declines in these situations have an outsize impact on the less liquid parts of the market,” he says. Conversely, if the Fed pivots on rates, “it will throw the market out of whack and could send investors back to the high-yield market”.
Another concern is the refinancing wave that is expected to occur in the next two to three years, given that the three most active years for debut corporate issuers were 2017-19, according to Marathon. Because some 40 percent of the BSL CLO market is scheduled to exit reinvestment by the end of 2023, those managers won’t be able to buy new loans unless spreads tighten, says BofA’s Gupta.
Already, primary issuance has slowed sharply. Although new issuance in the CLO market is on track to total about $120 billion this year – the third-highest volume since the GFC – third-quarter issuance fell 40 percent from the year-ago quarter, to just $33 billion, one of the lowest quarters since the financial crisis, according to PitchBook LCD. “If you can’t make more CLOs, and AAAs on the secondary market are trading at 90 cents, why buy a new one?” says Atalaya’s Zinn.
Meanwhile, investors are starting to look for yield in the more liquid fixed income markets. An October poll by consultancy bfinance found that 24 percent of UK investors expect to reduce their private market exposure over the next 18 months, while those expecting to increase their fixed income exposure rose from 25 to 29 percent. “The classic thing I hear from people trying to put deals together is, ‘Why would I do this, when I can buy an investment-grade public issue at the same price?’,” says Richard Wheelahan III, co-founder of Fund Finance Partners.
Says Apollo’s Leas: “If the natural buyer base starts to sell all at the same time it will cause a very fast drawdown in prices.”
Some market participants say that could happen if banks stop providing liquidity or if big Japanese banks, which are estimated to hold 25 to 40 percent of CLO AAAs, begin selling, although most consider this to be unlikely. Others say that if the Bank of Japan removes its yield curve control and the yen begins to rally, domestic investments will become more attractive. Indeed, one big Japanese investor, Norinchukin Bank, was reported in October to have abruptly exited a deal midway, something that almost never happens in the CLO market.
But markets could surprise to the upside. “What’s priced into the high-yield and loan market is a massive recession,” says Ted Goldthorpe, a partner and head of BC Partners Credit. “If those expectations are less bad, people could benefit.”
Moreover, despite the expected volatility, Leas notes that CLOs have weathered previous market swoons thanks to structural protections and diversification. “This doesn’t mean it’s without risk, but the asset class offers significant protections and credit enhancements that are often underappreciated by the broader market.”
Nevertheless, the market could be easily roiled. As Wheelahan puts it: “People are capable of making all sorts of spectacular mistakes during periods of dislocation.”
That will inevitably create opportunities for some. Art Penn, chief executive officer of PennantPark, a $300 million mid-market CLO, finds the current environment very attractive. He quoted Warren Buffett as saying: “Be fearful when others are greedy and be greedy when others are fearful.” In that respect, this time really is no different at all.