Increased default and downgrade risk for CLOs
The US CLO market has thus far sailed through the storms of 2021 and 2022 in eminently seaworthy condition. However, with recession now looming, the sector faces increased downgrade and default risks.
“Loan defaults have started to pick up in the US since August, and six loans totalling US$12bn have defaulted. Meanwhile, loan downgrades have also escalated in some of the largest sectors in US CLO collateral, such as technology, health care, consumer products and telecoms,” says Maggie Wang, global head of structured products strategy at Citi.
Wang will be sharing more of her thoughts next week at IMN’s ABS East Conference (17-19 October) in Miami, Florida. She is speaking at the CLO equity roundtable on Tuesday afternoon at 4pm EST.
The underlying collateral is also displaying signs of market weakness. Loans trading below 60 cents on the dollar now account for 1% of all collateral, and those trading below 80 cents account for 4.4% of the collateral pool. These are the highest levels seen since the early days of the pandemic - which was short-lived anyway - and mid-2016.
More and more deals are also exceeding the triple-C threshold as a result of downgrades. As measured by S&P at the end of September, some 5% of all CLO deals breached the triple-C barrier, or 4.5% as measured by Moody’s.
An increase in defaults and downgrades will lead to an increasingly wide bifurcation between mezzanine and equity tranches - which has been widening anyway over 2022. Equity tranches have dropped in price from 50 points on the dollar in January to about 36 points at the end of September.
Investment grade CLO debt prices have not been immune to negative price action either. Debt tranches have widened this year by between 107bp and 378bp, with particularly savage spread widening seen last month in the wake of Federal Reserve Chair Jerome Powell’s uncompromising message at Jackson Hole and the now widespread belief that only the depth and the length of the imminent recession are now in question.
In the five days following the September FOMC meeting, at which rates were hiked by another 75bp, CLO debt widened by between 28bp and 65bp across tranches.
In view of these headwinds, CLO issuance is expected to slow down until the market finds a point of stabilisation. Citi still believes that this year will see US$120bn of new supply, which indicates just another US$10bn before year-end.
Nonetheless, while equity tranches are in for an exacting period, investment grade CLO tranches will remain resilient, says Wang. “We run stress tests all the time and CLO triple-B rated tranches and above are extremely unlikely to crack, even if economic conditions worsen. This confidence has underpinned CLO liquidity and supply, which has been the most important surprise of the year to date,” she says.
Supply in CLO BWICs had increased by 89% year-on-year by the beginning of October. This surge was led by a 194% increase in triple-A tranches, but double-As increased by 82%, single-As by 81% and triple-Bs by 53%.
For the greater part of the year, increased volume has been met by solid demand. The did-not-trade (DNT) ratio for investment-grade rated CLO debt tranches has never exceeded 13%.
Indeed, there has been very healthy secondary market supply, in the face of the gathering volatility. This is due to a number of different factors.
First, investors have been selling outperforming CLOs to raise cash and reinvest in cheaper assets. At the same time, asset managers have been rotating to safer investment grade classes.
The split between debt and equity tranches is expected to increase rather than lessen. Despite the gloomy economic picture, the structure of investment grade CLOs is trusted to protect investors from calamitous loss; this is much less true of equity tranches.
At the beginning of 2022, the abolition of Libor hung over the market like a threatening cloud. By far the greater part of CLO collateral referenced Libor, and yet new CLO deals could not be priced against Libor any more. The possibility of grievous mismatch was everywhere.
A degree of basis risk is always inherent in the CLO market, as the underlying leveraged loans often allow the issuer to take a different Libor term every month. But with the advent of SOFR, the risk became more complicated.
However, while 83% of CLO collateral still references Libor, the market appears to have negotiated this particular minefield adroitly. “The transition has been much smoother than people thought it would be. There was a difficult time leading up to the changeover, but the market worked it out,” says Wang.
There was a round of price discovery deals at the beginning of the year, aided by reams of research - and nine months on, the change to SOFR is no longer a troublesome issue. “The market settled down to a consensus in two to three months,” Wang concludes.