Corporate America’s refinancing boom is creating major headaches for some of its biggest lenders, collateralized loan obligations.
Leveraged loans are in high demand because they pay floating rates of interest and tend to perform well in a rising rate environment. Since few companies are taking out new loans, borrowers are able to demand lower interest rates from existing lenders.
This puts CLO managers in a bind: If they accept lower interest payments, there will be fewer funds available to service their own debt. They also risk running afoul of a portfolio metric intended to protect investors.
Allowing borrowers to repay them early isn’t a great option either, since there are few attractive places to put the money back to work.
CLOs investing in Regal Cinemas, for instance, have endured three refinancings of a $954 million loan that has been refinanced three times since May 2016. This has resulted in a cumulative reduction of 75 basis points in the spread that the loan pays over Libor to 200 basis points from 275 basis points originally.
“The loan market is refinancing at a significant pace that I haven’t seen since 2006,” said Eddy Piedra, vice president of leveraged loans for 40/86 Advisors, an affiliate of CNO Financial Group that both manages and invests in CLOs.
“It’s definitely having pressure on excess interest,” which is needed both for repayment of the principal of senior notes issued by CLOs and of distributions to holders of the most subordinate securities issued in these deals, known as the equity, Piedra added.
All told, some $300 million senior bank loans have been refinanced so far this year. As a result, the weighted average spread (WAS) on U.S. CLOs, or the difference between the yield on loans in a portfolio and the cost of debt issued to fund the purchase of the loans, has fallen substantially. It stood 3.75% in May, down nearly 50 basis points (from 4.72%) from the same period a year earlier, according to Fitch Ratings.
A significant number of CLOs are now falling short of minimum WAS levels stipulated in deal documents.
As of May, 20 of 278 CLOs rated by Fitch and issued from 2014 to 2016 were failing their weighted average spread tests. Another 140 CLOs, representing 50% of the agency’s rated universe, have a cushion of less than a 10 basis points left before breaching their deals’ minimum spread compliance.
Compounding their stress, CLO managers are finding it difficult to take any action that would boost spreads. The supply of higher quality loans is so limited that they must trade down in credit to find additional yield. Yet buying riskier loans can jeopardize a portfolio’s compliance with other covenant tests, including asset quality.
Mike Herzig, managing director at THL Credit Advisors, likens striving for balance between risk and spreads to squeezing a water balloon – containing one problem only manages to exacerbate another.
“You cannot do it all,” he said. “You’re going to have to sacrifice somewhere.”
The problem is most acute for CLOs printed in the past couple of years. Managers of deals that have exited their non-callable periods (typically two years) can themselves refinance, forcing their own investors to accept lower interest payments.
However, some older CLOs grandfathered from risk retention requirements risk triggering compliance if the refinance. (It is possible, under certain circumstances, to refinance older deals without triggering compliance, but only once.)
The consequences for deals that flunk covenant tests are often “maintain and improve” trading restrictions, which limit managers to acquiring new collateral that remedies a failed (or nearly failed) test. In some cases, managers may be prohibited from acquiring additional loans until the test is satisfied, according to Wells Fargo.
Things can only get worse.
Wells Fargo estimates that another $191 billion of loans will exit their non-call periods and be refinanced by the end of August. That will not only place more lower-yielding assets into the market, but introduce declining credit quality into the mix as firms with shakier credit find easier access to capital.
Wells Fargo thinks the continued run of refinancings and repricings could shrink average WAS levels another 14 basis points with CLOs by the end of summer, putting CLO managers under additional pressure.
JPMorgan has a similar view. On Tuesday the investment bank boosted its forecast for full-year leveraged loan issuance to a record $800 million, an increase of $250 million from the level it was calling for in January. It expects just $300 million of this to be new issuance.
CLOs aren’t the only ones looking for places to put their money to work. With interest rates headed higher, money is flowing into the loan market from other sources including retail mutual funds and exchange-traded funds. Loans are now changing hands in the secondary market at a premium to par, or face value. The percentage of leveraged loans trading above 100 cents on the dollar reached 74% in February, though it has retreated to a three-month low of 62.6% as of June 20, according to JPMorgan. But either compares unfavorably to the 2% of leveraged loans traded above par in February 2016.
CLOs that fail portfolio tests can apply one of two fixes: They can acquire new collateral, or commit future reinvestments to adjustments in a portfolio’s asset quality “matrix” – a combined measurement of spreads, collateral diversity, combined average ratings and recovery ratings.
In this matrix, a manager wanting to boost spreads by acquiring riskier assets could make changes to the diversity or the average pool ratings factor, so long as the cushions in those areas protecting investors are not breached while gaining the higher average spread.
This is the choice many managers are making, said Piedra. “A lot of managers are pretty well diversified, so to move the needle on spreads takes a lot of trading in the portfolio.”
According to Fitch, over 92% of managers of 2014-2016 vintage CLOs have chosen to adjust for spread tightening by tweaking the cushions on their diversity or average ratings factor scores that measure, respectively, their issuer and industry concentrations and the percentage of lower-rated assets in their portfolios.
“Managers face a tough decision,” Herzig says. “Do I go down in quality to keep my spread high, or do I not maintain the credit quality I would love to keep?”
While THL is not prepared to make this tradeoff, Herzig added, “we’ve seen a lot of managers choose the former, and we’re in a benign credit environment, so maybe it’s fine. They can junk up the portfolio a bit and buy stuff with a little more yield.”
Loan refinancing is putting CLOs out of compliance with yet another covenant called weighted average life (WAL), which measured the average time that it takes a dollar of principal to be repaid on a deal. That’s because refinancing typically involves extending the term of a loan, in addition to lowering the interest rate. Wells Fargo reckons that 55% of 2012-2013 vintage CLOs are failing. Another 12% of 2014 vintage CLOs are also failing, while another 34% of this vintage has a WAL cushion of less than 0.25%.
CLO managers respond to failing WAL tests by purchasing shorter-duration loans, but this, too, typically has a negative impact on asset quality.
“If managers compensate for WAL test pressure by buying shorter loans, the credit quality of the portfolio could fall, since shorter loans are likely those that were unable to refinance due to credit concerns (or possibly due to very tight coupons, which would further pressure WAS tests),” analysts at Wells Fargo wrote in its June 12 report.
