With market participants wondering where to look for signs of the next downturn’s arrival, the publication of a report from the Financial Stability Board, the Swiss-based regulator, had heads turning towards the collateralised loan obligation market.
The report indicates that loosening loan standards are making more leveraged loans and CLOs vulnerable to economic shocks. It also warns that if problems in leveraged loans and CLOs become too serious, they could infect the rest of the financial markets as the size of the CLO market, and the banks’ involvement in it, continues to grow.
Moreover – in talk ominously redolent of the global financial crisis – the report says assessing risk in the CLO market is difficult because of the complexity of the relationships between corporate borrowers, private equity firms, leveraged loan and CLO issuers, and banks.
In the March issue of Private Debt Investor, our cover story will examine the CLO market and attempt to draw some conclusions about whether there really is much to worry about. One source told us they had attended a recent CLO conference expecting to see anxious faces. Instead, “it was hard to schedule meetings because managers were too busy talking to investors”. These investors, it should be added, were still looking to put money in rather than make withdrawals.
There are other indicators that concerns may be exaggerated. Some took the flight from the market by Japan’s Norinchukin Bank last year, following a mild warning about the market from the country’s central bank, as a sign that all was not well. But when other institutions quickly stepped in to snap up the AAA tranches Norinchukin had been greedily consuming, it only served to underline the continuing attractiveness of CLOs.
Of course, AAA paper is hardly the riskiest and it’s at the other end of the risk spectrum that attention has been focusing. The proportion of B and C rated paper has been steadily climbing, and many B- loans in the market today are considered at risk of downgrade to CCC status by ratings agencies that took the heat during the crisis and are loath to do so again. Many think twitchy trigger fingers at these agencies could lead to a surge in downgrades, perhaps even before significant problems have emerged.
But although there may be headwinds, many CLO players are currently surprised only by the negative views of their market. How things unfold from here will be fascinating to observe and will tell us who has the most reliable perspective: the confident insider or the worried outsider.
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