As leveraged loan downgrades multiply, CLOs are wary of triple-C limits
As single B-rated debt continues to gain market share in the US $ 1.18 trillion leveraged loan segment, regulators and senior market watchers are increasingly concerned about the fact that large-scale debt downgrades could cause significant problems for secured loan obligations – by far the largest leveraged loan investors – who have limits on how much triple-C paper they can to possess.
This scrutiny of CLOs and downgrades has come to the fore lately amid lingering concerns about the U.S. and global economies, the health of an already aging credit cycle, and growing levels of riskier debt.
At the latter point, the share of U.S. leveraged loans rated in the simple B range has increased significantly in recent years, driven by demand from yield-hungry investors, driven in part by rising interest rates. interest in 2016-2018. Leverage loans are variable rate instruments, which tend to attract investor dollars in a rising rate environment. In September, around 56% of the issues underlying the S & P / LSTA Leveraged Loan index were rated B +, B or B–, compared to 45% at the start of 2017. And the portion of debt rated B- represented 13%. outstanding loans at the end of September, i.e. almost double their share at the start of 2017.
Perhaps most notably, the share of outstanding loans rated triple C was 7.5% at the end of September, the highest level since July 2013. This is up from 6.3% in June 2019.
The specter of a downgrade of leveraged loans to the triple C level could be a challenge for a CLO investor base that buys nearly three-quarters of all currently syndicated U.S. leveraged loans, and holds 55% at 60% of all outstanding leveraged loans, according to LCD.
In fact, the majority of CLOs have a limit of 7.5% on portfolio securities rated CCC + / Caa1 or less. CCC’s median share of holdings in US CLOs is currently 4.1%, according to Wells Fargo Securities. This share has varied from 3% to 4% since 2016.
While the CCC share should be watched, the 7.5% limit is not necessarily a hard cap, as the market value of CCC paper above 7.5% would then be deducted from a junior overcollateralization test of a. CLO, or OC. Wells Fargo analysts, led by David Preston, believe those tests would not fail until CCC’s holdings hit 12%.
It is the failure of this test – which is triggered for a CLO only when a number of loans default, are sold at a loss, or the portfolio has excess CCC assets – that results in out-of-pocket payments. the most junior equity tranche of a CLO to divert, to pay off the most senior tranches instead. Apart from these factors, the junior OC test cannot be triggered solely by a decline in the market value of the underlying loans.
Downgrades are accelerating
Highlighting concerns about downgrades, some outstanding loans that are currently experiencing difficulties are downgraded to this CCC critical rating. Already, the rating agencies have downgraded more names this year than the previous two.
Until October 11, 282 issuers of the S & P / LSTA index were downgraded, up from 244 in 2018 and 33 in 2017 (there are currently 1,460 issues in the index). Putting these numbers into perspective, the ratio of downgrades to upgrades rose to 2.9x in the 12 months to September, the highest number since November 2009, and from 2.1x in 2018 and 1.6x in 2017, according to S&P Global. The last time there were more upgrades than downgrades on a rolling 12-month basis was in October 2015, when the ratio stood at 0.9x.
In general, credit quality deteriorated sharply as the year 2019 progressed, with the downgrade / outplacement ratio reaching 4.9x in Q3 (three-month rolling), compared to 2.6x in Q2 ’19, and from 2.3x in Q1’19.
Sectors with the most downgrades this year include business equipment and services (11% by number), healthcare (10%), electronics / electrical (9%), oil and gas ( 7%) and non-food and pharmaceutical retailers (7%). Seeing professional equipment and services, healthcare and electronics at the top of the list is not necessarily surprising, as these segments are also the largest sectors of the overall leveraged loan market. The first two each represent around 10% of outstanding loans, while electronics represent 15%.
More revealing than the absolute number of downgrades by sector is the change in sector composition from year to year. Health care is among the most degraded sectors, in percentage change, with 27 downgrades as of October 11, against 12 in 2018, an increase of 125%. At the same time, electronics / electricity (an indicator of the tech sector) saw a 26% drop in downgrades, while downgrades in retail (other than food / drugs), a sector that suffered a wave of defaults earlier in the credit cycle, fell 21%.
Regarding the distribution of marks, out of the 282 downgrades this year, 27% (75 establishments) went to B–, and 15% (43) to CCC +. This is a noticeable increase from last year when 20% of downgrades moved to B– and 11% moved to CCC +.
Sell first, ask questions later
CLO managers, however, do not wait for rating agencies to act. Instead, they seek to distance themselves from any shortfall, especially as managers find that cash is disappearing quickly on a number of names.
The share of negotiated loans under 90 held by CLOs rose to 9.5% in October, from about 8% in September and 6.5% in August, according to data from Wells Fargo. And 4% of CLO loans traded below 80 in October, up from 3% in September and 2% in August. Most of the loans sold were lower B-rated loans and were not part of a widespread liquidation, as double-B-rated loans remain highly rated.
Even more dramatic, such a liquidation was observed over the summer under the $ 782 million B term loan. Luxury Entertainment Services Group Inc., which began to drop from the mid-90s in July to 36-43 in early August, as the proposed split and equity injection did not go as planned. Shortly thereafter, S&P Global Ratings downgraded the issuer’s rating to CCC – from B–, while Moody’s followed suit a few days later, downgrading the loan to Caa2 from B3.
The credit is held by a number of CLO managers, many of whom were unwilling to participate in additional funding for the company after the downgrade as they were reluctant to double their additional exposure to CCC at this point.
“You don’t want to fill your CCC buckets now,” said a CLO official, adding that “for every CCC loan today there will probably be three or four more in the next few years.”
Additionally, many CLO managers have not been allowed to participate in bridge financing because a major insurance company / CLO investor does not like investing with managers who allow them, sources said.
As a result, with existing investors not being able to provide sufficient funding, Deluxe Entertainment had to officially apply for a prepackaged Chapter 11, securing a DIP loan instead. Last week the loan traded at around five o’clock.
Watch out for the gap
Thus, as CLOs remain the largest buyers of leveraged loans, questions remain as to who will step in to buy certain loans when CLO managers do not want to or when they cannot for structural reasons. .
Dealers, faced with more limited balance sheets in recent years, have also been unable to offer bids at these levels, in some cases only offering bids well below current levels.
And while a significant amount of capital has been raised from funds targeting struggling strategies, these investors have at times expressed reluctance to get involved at lower levels, as the inability to have quarterly earnings calls. or bringing a borrower back to the negotiating table potentially leaves investors operational. in the dark.
“Under 80, up to around 60, you find yourself in no man’s land,” said a CLO official.
CLO managers who buy new loans at these levels (without replacing another loan at that level, using what is known as a discount bond swap) may have less incentive to do so, in part because ‘They are required to mark credits at their purchase price, for the purpose of OC testing, as opposed to those purchased at 80 or more, which may be marked at par for testing.
Another potential problem is that CLO managers who buy lower-rated credits can come under scrutiny from their tranche investors.
“A manager must not only have a lot of conviction about an asset to buy it between 60 and 80 (and the willingness to explain such conviction to investors in the CLO tranche) but also have room on their OC, CCC tests. , WARF and others in case the asset is then downgraded before eventually trading higher, ”Barclays analysts wrote on Oct. 11.
A WARF, or Weighted Average Rating Factor, measures the credit quality of a portfolio.
One of the ways these issues are handled is through a handful of CLO managers who have turned to issuing “enhanced CLOs,” which allow up to 50% of portfolios to hold debt rated CCC + or less. , a considerable difference compared to standard 7.5. %.
So far, the only such deals have been signed by Z Capital Credit, Ellington Management and HPS Loan Management, to which others, such as Par-Four Investment Management, are expected to join. Investors will stress that timing is essential for these CLOs. Given the much higher expected risk of the portfolio, tranche investors on these vehicles expect to be better remunerated.
For example, HPS Loan Management on its improved Strata CLO I must pay 257.97 basis points for its commitments, compared to its more standard CLO from months earlier, which was 169.71 basis points.
“You can’t just hide in BB rated loans while waiting for the market to turn around,” a CLO official said. “But that doesn’t mean you have to buy every triple-C up front, either.”
This story was written by Andrew Park, who covers the US LCD CLO market.
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