CLO engineering is no match for Covid-19 as payments get cut off
Wall Street’s engineering was supposed to turn loans to junk-rated companies into relatively safe bonds known as collateralized loan obligations. As the new coronavirus slams the economy, some investors are finding that safety to be fleeting.
Interest and principal payments are at risk of being cut off for investment-grade CLOs in around a dozen different transactions totaling a few billion dollars, according to people with knowledge of the matter. The notes at risk have ratings as high as the A tier, well within high-grade territory, and were sold by name-brand money managers like Marathon Asset Management and Pretium Partners, the people said.
The securities are being battered as the Covid-19 pandemic is bringing an economic downturn far worse than many CLOs were designed to withstand, with some estimates for unemployment in the second quarter reaching 30%. Loans are getting downgraded and their value is dropping, which is triggering protections designed to protect the safest securities issued by CLOs, those rated AAA.
It’s the first time these safeguards, known as senior overcollateralization tests, have been this widely triggered since the 2008 financial crisis. Many more deals could meet the same fate in the coming months. CLOs, a $700 billion market of securities carrying ratings ranging from junk to AAA, were largely left out of Federal Reserve stimulus programs.
“I don’t know anybody that modeled a CLO, or any other structured product, around unemployment soaring from about 3% to the levels we could be facing in the next few weeks,” said Elen Callahan, head of research at the Structured Finance Association, a trade group. “If you told an analyst to model that, they wouldn’t know what to do.”
The lowest-ranking securities sold by CLOs are most at risk. Of the roughly 900 deals that have posted data over the last month, around 21% have had cash payments cut down or cut off from the riskiest portion of their deals, known as the equity, according to Bank of America. In certain cases, junk-rated notes, which are less risky than the equity, have been affected as well. In mid-April, some analysts were expecting as many as 1 in 3 CLOs to have to limit payouts to holders of their riskiest securities.
Prices can end up dropping on securities in a deal where payments have been cut off, because investors worry about the quality of the loans backing the transaction, said Jason Merrill, a CLO specialist at Penn Mutual Asset Management.
“It’s broadly considered a sign of deal distress,” Merrill said.
While investors might expect high-yield securities to suffer in a downturn, investment-grade instruments are supposed to be less vulnerable. During the last financial crisis, CLO bonds rated AA or AAA saw no defaults due to downgrades of the underlying loans. The default rates for A and BBB rated notes were infinitesimal, amounting to less than 0.01%, according to the Structured Finance Association’s Callahan.
Bondholders could face curtailed payments as CLOs fail the senior over-collateralization tests, which require the value of the loans a CLO holds to exceed the value of the bonds it issued by a sufficient amount. Failing that requirement results in interest and principal payments getting deferred on the bonds and cut off to equity. Those are instead diverted to pay down the safest notes issued by the CLO.
CLOs issued by firms including Marathon, Pretium and Jefferies Finance have failed these tests. If the portfolio grows in value sufficiently over time relative to the liabilities, the failure is “cured” and payments to investors can resume. With the Jefferies transaction, it used cash built up from loan repayments that couldn’t be used to buy new loans, since the CLO’s reinvestment period had ended, to remedy the deal’s breaches.
Representatives at Pretium, Marathon and Jefferies declined to comment.
CLO portfolio managers can sometimes cure their shortfalls through skillful trading, but loan downgrades have come so fast that many managers were unable to shed poorly performing loans quickly enough in recent weeks. Even more transactions are failing less stringent tests of whether the deal has enough collateral, known as interest-diversion tests.
“We are only at the beginning of the first inning of seeing significant distress in the leveraged loan market,” said Michael Barnes, executive chairman at Tiptree Inc., and founding partner of Tricadia Holdings, an investment manager that also issued CLOs. “It may severely impact equity, BBs and possibly BBBs with capital losses in the coming years.”
The record surge in downgrades has pushed more CLOs to sell loans they own: debt to companies rated CCC can usually only account for about 7.5% of the holdings of a portfolio backing a CLO under the terms of the securities.
With recent rating cuts, many portfolios saw these limits exceeded. CLOs have to mark those excess loans at their market trading price, which effectively lowers the value of the collateral. That can spark more overcollateralization-test breaches, potentially creating a downward spiral.
There will almost certainly be more CLOs selling loans, depressing the value of their assets further. There’s little sign that the businesses paralyzed by the pandemic can soon return to normal levels of revenue generation that would improve their financial standing. Moody’s Investors Service placed about $22 billion of CLO securities -- which get rated separately from their underlying loans -- on watch for a downgrade earlier this month, citing the deterioration in corporate credit quality.
CLOs have these tests to protect the senior bondholders. Market participants tout them as mechanisms that specifically fortify CLOs against credit shocks, although whether they can outlast a shock of this magnitude remains to be seen. Bank of America said in a report earlier this month that failing overcollateralization tests for investment-grade portions of transactions likely hasn’t happened since the 2008 financial crisis.
Here are some of the deals that have failed overcollateralization tests for investment-grade securities:
- The Pretium deal, called Crown Point CLO 6, was a reset of a deal originally issued by NewMark Capital in 2014. Pretium agreed to acquire two of NewMark Capital’s CLO assets in 2018. The Marathon deal, CLO VI, was issued in 2014, and its re-investment period, or the period during which the CLO manager trades in an out of loans, ends next month meaning it had less flexibility to remedy the breach.
- The Jefferies deal, Apex Credit CLO 2015-II, used loan repayments that it hadn’t re-invested in new debt to effectively “cure” the breach and ultimately then passed the tests, one of the people familiar with the matter said.
- A middle-market CLO managed by ArrowMark Partners, Peaks 2014-1A, breached its senior OC test. The deal has more exposure to larger loans than typical middle-market deals. It’s the only deal of ArrowMark’s CLOs to have breached an OC provision. A representative for the Denver-based firm declined to comment.