For the first time since the financial crisis, the most senior debt tranches in a number of CLOs have tripped their overcollateralisation tests. This signals that the economic effects of the coronavirus pandemic are starting to spill over into even the least risky parts of the CLO capital stack. CLOs are structured credits whose underlying portfolios consist of senior secured bank loans, typically made to businesses that are rated below investment grade.
Overcollateralisation tests help keep the principal value of a CLO’s underlying bank loans from exceeding the total principal value of the notes issued by various CLO tranches while the CLO debt is outstanding. When they are breached, cash is likely to be diverted from the equity and junior rated tranches to the senior debt.
Some observers maintain that the structure of CLOs, which fared reasonably well during the financial crisis, should protect them from the large-scale pain that similar derivative instruments such as residential mortgage-backed securities and collateralised debt obligations suffered during the 2008 market shock. But the longer the economic carnage drags on, the greater the potential for price pressure on the CLOs as the excesses, which were driven by the search for yield that resulted in a lowering of credit quality, wind down.
“As others have said, we’re seeing the previews; the movie is still to come,” says Philip Galgano, senior director and head of ratings at Egan-Jones, an independent credit rating agency. “All the noise coming out of the market looks an awful lot like what happened with RMBS,” he notes.
“What we learned from 2008 is that there are things that happen early in a credit crisis that portend the scope and magnitude of the crisis,” says Richard Wheelahan III, founding partner of Fund Finance Partners, an advisor to asset managers. “Overcollateralisation tests being tripped in the senior tranches so quickly into a down cycle is one of those signals.”
To be sure, there are important distinctions between CLOs and the asset-backed vehicles that nearly brought down the financial system in 2008. For one thing, leverage in a collateralised debt obligation or a mortgage-backed security is higher than in a CLO, says Jonathan Sloan, managing director in Houlihan Lokey’s portfolio valuation and fund advisory services business. And, unlike RMBS, there is “true diversification” with the corporate loans that underly the CLO debt, which is spread across different industries.
This time, the owners of the CLOs are in “much better shape” than they were in the financial crisis, both because of the underlying collateral in the CLOs and the sturdiness of CLO holders, Sloan says.
Unlike the hedge funds that needed to raise cash to satisfy margin calls in 2008, CLOs today, even in the lowest tranches, are frequently held by large institutions or closed-end funds with dedicated strategies. Moreover, last time, debt that had been routinely and perhaps too often rated triple-A and that was trading at par, plunged to 20 cents on the dollar.
In March, although spreads in the senior debt of the CLOs widened when the market froze up, “that was only a measure of liquidity risk – not true credit impairment,” Sloan says. And spreads have since come back in.
Nevertheless, “the pace of the loan downgrades took everyone by surprise,” says Pratik Gupta, a CLO/RMBS strategist at Bank of America Securities. From March to the end of May, nearly 30 percent of the leveraged loans in CLO portfolios was either downgraded or placed on CreditWatch with negative implications by S&P Global Ratings. That caused the triple-A and double-A debt tranches to breach their tests, Gupta says.
As of 5 June, a full 19 deals were failing their triple or double-A overcollateralisation tests, while 43 were failing their single-A tests and 121 their triple-b tests, according to Bank of America Securities. Typically, failure of tests on the highest rated debt would result in coupon payments to mezzanine tranches being deferred until the breach is corrected, or interest payments on the loans that would ordinarily go to equity holders being diverted to paying principal on the higher-rated debt.
Because of the economic paralysis created by the response to the pandemic, the share of loans in CLO portfolios that are rated triple-C, or extremely high risk, tripled from 4.13 percent at the beginning of March to 12.12 percent by 31 May, according to S&P Global.
The increase in ratings downgrades on CLO portfolio loans and their debt undoubtedly will continue to pressure pricing, as will any bankruptcy-related defaults. Indeed, American Airlines, which reportedly is nearing a bankruptcy filing, is instructive. Fitch Ratings downgraded the ratings on aviation company’s $34 billion of debt twice in two months, to single-B in late April, amid a steep drop-off in travel. The price of American’s credit default swaps skyrocketed 4,000 percent over the past three months.
According to Trepp’s CLO data, the company is represented in the CLO market by four loans, each more than $1 billion. The trading price of its $1.8 billion American Airlines Term Loan, which Trepp said is held by more than 250 CLO vehicles, plummeted from at or around par in February to the mid-$60s in the middle of May, according to IHS Markit.
KKR Leveraged Credit noted in its first-quarter letter in April that it expects the downgrades “to continue to pour in, and this will create technical selling pressure in the CLO community, which represents about 60 percent of the leveraged loan buyer universe.” Moreover, the letter went on, “the sheer volume of downgrades across this very large buyer pool of the loan market” will add to the market’s continued price pressure. KKR noted that while 10 percent of the bank loan market was trading below $90 at the end of 2019, a full 95 percent of the Leveraged Loan Index was under $90 on 20 March.
This spells trouble for the lowest levels of the CLO capital stack. “This time, CLO equity is going to suffer a lot worse than 10 or 11 years ago,” Gregory Racz, president of MGG Investment Group, said during a virtual roundtable on the pandemic and the credit crisis hosted by Clade and Boston Private. He cited the worst economy and unemployment levels since the Great Depression, record-high consumer debt and higher corporate debt with poorly structured covenant-lite loans.
“A tremendously leveraged loan market intersected with a tremendously bloated CLO market,” said Daniel Zwirn, chief executive officer and chief investment officer of Arena Investors, at the same roundtable. “Every rational speed bump got kicked away, and now you’re seeing the chickens come home to roost.”