Add Southcross Energy Partners, Seventy Seven Energy, Verso Corp., and Paragon Offshore to the list of credits held by collateralized loan obligation that appear to be headed for default.
These four names, along with Arch Coal, which filed for bankruptcy this month, account for a combined $1.4 billion in U.S. CLO collateral, according to Wells Fargo and Intex. That represents just 0.33% of the currently outstanding U.S. CLO universe. The median U.S. CLO exposure to the combined five issuers is 0.55%.
Southcross is the biggest exposure in U.S. CLOs, with $507 million; on Jan. 8, it suspended investor distributions and hired financial advisors.
Seventy Seven Energy hired financial advisors to review the company’s capital structure, per Bloomberg, on Jan. 12.
Paragon Offshore has deferred an interest payment and has a 30-day grace period before an event of default.
And Verso is preparing to file for bankruptcy protection as a grace period on a missed interest payment nears expiration.
And U.S. CLOs hold a total of $337.3 million of Arch Coal debt, per Intex.
Of the 434 U.S. CLOs with exposure to any of these five issuers, only 98 have combined exposure of at least 1% to these issuers.
By vintage, 46.6% of total U.S. CLO exposure to these five issuers is in the 2014 vintage; 20.1% is in the 2013 vintage. Vintage 2015 deals have 13.1% of the total U.S. CLO exposure to these issuers.
As of year-end 2015, CLOs held 1.2% in defaulted assets. For context, the volume weighted default rate was 1.5% at the end of 2015, per LCD.
What’s a CLO manager to do?
CLO managers can trade out of a security deemed to be a credit risk due to a price change or default. (They can also sell securities that have appreciated in order to lock in profits.) These discretionary trades are typically limited to 20-25% of the portfolio per year.
When a credit defaults, managers must often choose between cleaning up a portfolio and running afoul of various coverage tests, such as overcollateralization and interest coverage. The OC tests measure the par of a CLO’s assets relative to the par of the CLO’s debt. The IC tests measure how much interest the CLO collects relative to the interest cost of the CLO’s debt. At issuance, the tightest coverage tests typically have 3-4% cushion from their required threshold.
According to Wells Fargo, managers that sell defaulted loans may actually be doing better for investors in the long run; selling may cause a par loss but prevent a larger loss later drop in overcollateralized cushion. “By exiting troubled credits, even at a par loss, the manager may be able to be more flexible during a larger credit downturn,” CLO analyst David Preston wrote in a report published Friday. “While cleaning up the portfolio may not help net asset values, it will improve price bucket and portfolio average prices.”