CLO reckoning arrives: downgrade wave tests $700 billion market

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As U.S. financial markets have rebounded feverishly this past month from the worst of the coronavirus-induced sell-off, one asset has been conspicuously absent from the rally: the collateralized loan obligation.

Prices in key parts of the almost $700 billion market -- which through large doses of Wall Street alchemy provides financing to companies with less-than-stellar credit scores -- have remained deeply depressed, typically fetching less than 70 cents on the dollar. Back in February, before the Covid-19 pandemic throttled the economy, they hovered near par.

Part of the reason for this is the simple fact that CLOs, as the securities are known, have been largely left out of the stimulus programs hastily crafted by U.S. officials to shore up markets. But there’s a bigger and more ominous force at work that has investors bracing for the kind of pain they’ve never experienced in the decades that the market has existed.

Credit ratings on risky corporate loans that were stuffed into the CLOs are being downgraded at a pace so frenetic that it threatens to overwhelm safeguards that were put in place to ensure the securities’ financial strength. And if that happens, the firms that manage the CLOs will be forced to dump under-performing debt at fire-sale prices or suspend the cash payments they hand over to their investors.

Some analysts expect as many as one in three CLOs may soon have to limit payouts to holders of the riskiest and highest-returning part of the CLO structure -- the equity portion. Others say the pain could quickly spread to those invested in less risky tranches, too.

The exact extent of the damage will become clearer in the coming weeks as managers submit monthly and quarterly updates of their assets, which will be used to determine whether they’ve breached key thresholds on quality and solvency.

These risks prompted Moody’s Investors Service to warn on Friday that it may cut the ratings on 859 CLO securities, accounting for nearly a fifth of all such bonds it grades. (The downgrades would be different than the ones on the underlying loans that have already been piling up; they would apply to the CLOs themselves.)

The loan downgrades have come so fast, one after another, that Stephen Ketchum of Sound Point Capital Management likened it to a spill “at the Daytona 500, where the cars are crashing into each other.” It’s a lot different, he said, than the 2008 financial crisis, which “was a slow-moving train wreck.”

The other big difference between then and now is that back in 2008, the CLO market emerged largely unscathed, an outcome that seems unlikely this time around. Corporate loans were far enough removed from the epicenter of the 2008 crisis -- a housing bubble -- to avoid much of the collateral damage and, besides, the CLO market back then was a fraction of its size today.

But that strong track record -- along with the fact that the securities provided juicy returns in an era of near-zero global rates -- fueled a boom in demand over the past decade.

In fact, CLOs are now the biggest buyers in the $1.2 trillion leveraged loan market, helping fuel a surge in debt-fueled buyouts and other transactions.

Prices on CLOs have recovered some in recent days, to be clear. AAA securities have managed to recoup most of their losses since the selloff began. But the rebound in lower-rated bonds has been much slower, with most BB notes still trading in the 60-cent range.

Some say there’s little room for more gains for now, given the pace of the downgrades. Already, between 17% and 19% of leveraged loans held by CLOs have been cut by Moody’s or S&P Global Ratings since the beginning of March, Bank of America Corp. analysts wrote in an April 14 report.

What makes matters worse is that CLOs entered this year with a record proportion of loans rated B- or B3 -- one notch above the lowest junk tier -- partly as private equity firms sought to load buyouts with more and more debt to juice returns.

As a result, the recent wave of rating cuts likely means the vast majority of CLOs are already breaching standard caps that limit the number of CCC loans they can hold to 7.5% of the portfolio, market watchers say.

That number is critical because holding too much CCC rated debt can force managers to begin marking their worst-performing loans at their trading price, rather than par. That reduces the average value of the portfolio and can trip asset-coverage tests, which causes cash-flow streams to certain investors to get turned off -- a mechanism designed to protect those who purchase less risky portions of the portfolio.

“Loan downgrades will keep coming and CLOs will be increasingly constrained,” said Andrew Curtis, head of CLO manager Z Capital Credit Partners. “CLOs will become more motivated sellers” of lower-rated loans.

While dumping under-performing debt may allow them to pass these compliance tests and keep the cash flowing for now, locking in losses during the depths of a selloff could cause even more pain down the road.

Yet that appears to be exactly what some are doing as B and CCC rated debt lags the broader leveraged loan market even as prices begin to rebound. The fact most managers have had only weeks to try to repair their portfolios ahead of calculations for April quarterly payment deadlines left them little room to maneuver, according Pratik Gupta, head of CLO research at Bank of America.

“It doesn’t leave managers much time to cure these buckets,” Gupta said in an interview.

Combined with a widely anticipated increase in loan defaults and lower recovery levels, the end result could ultimately be bigger-than-expected principal losses, said Chandrajit Chakraborty, chief investment officer at Pearl Diver Capital.

He expects as many as 20% of CLO mezzanine bonds -- those rated B and BB -- won’t be able to fully repay investors when they finally liquidate. That’s the sort of pain CLOs were largely able to avoid in the aftermath of the 2008 crisis.

Still, the alternative isn’t much better. Mangers choosing to hold onto lower rated loans face massive downgrades to the CLO securities they oversee in the coming quarters.

In addition to the Moody’s warning, S&P also on Friday put 155 CLO bonds on negative watch.

Deutsche Bank AG estimates that some securities currently rated as high as AA could ultimately get cut, forcing rating-constrained investors to sell or potentially bear higher capital charges.

Many in the industry see CLO mezzanine bonds falling further before the market recovers. Yet amid the volatility, some managers also see a historic opportunity to make money.

The best performing years ever for CLO equity were following the financial crisis, when portfolios were able to snag debt at beaten down prices. Post-2008 CLOs are also less levered than their pre-crisis counterparts, which should help the structures.

In addition, the flood of downgrades has undoubtedly left a number of loans mis-priced, according to Laila Kollmorgen, who buys CLOs as a portfolio manager at PineBridge Investments.

“The ratings agencies may have inadvertently downgraded a performing credit,” Kollmorgen said. “Good managers will benefit from knowing the difference between those credits that are rated CCC and will default, versus those that won’t.”

Eventually, savvy managers will emerge from the turmoil bruised but ultimately little worse for wear, according to Chakraborty.

“Most people who are able to weather this storm and aren’t forced to sell will come out well,” he said.

Still, many industry veterans say it’ll likely be rough seas until then.

“For the past few weeks, the top-tier managers have been furiously selling loans that have the potential to go to CCCs, and still the majority of CLOs will have problems with the CCC buckets, Sound Point’s Ketchum said. “The wild card is the rating agencies. Will they upgrade issuers if the economy snaps back as quickly as they downgraded them?”

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