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CLO managers taking cover from credit risk

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Fearing a near-term downturn, CLO managers appear to taking more active approaches to reduce exposure to distressed assets in their portfolios entering the fourth quarter.

Industry observers say managers are increasingly churning out of worsening loans due to concerns that assets could quickly deteriorate in ratings and prices that could cause stress to CLO caps on distressed assets and credit-quality performance tests.

They are also reducing exposure to certain sectors (retail, energy, commodities) being impacted by tariffs in the U.S.-China trade war.

Industry observers say managers are increasingly churning out of worsening loans due to concerns that assets could quickly deteriorate in ratings and prices that could cause stress to CLO caps on distressed assets and credit-quality performance tests. They are also reducing exposure to certain sectors (retail, energy, commodities) being impacted by tariffs in the U.S.-China trade war.

“I think they’re trying to build a cushion for themselves,” said Jason Merrill, a CLO investment specialist at $25 billion-asset Penn Mutual Asset management. “A lot of these guys do expect a material amount of [single-B rated] loans to be downgraded to triple-C.”

According to Intex data cited by Merrill in an Aug. 15 blog post, the concentration levels of loans rated CCC (or the equivalent Caa rating from Moody’s Investors Service) has declined to an average of approximately 0.7% in 2019, continuing a five-year trend of de-risking portfolios of volatile debt. (Most broadly syndicated loan portfolios have a maximum 7.5% ceiling on triple-C loans).

Merrill, who oversees CLO investments at Penn Mutual, said managers are increasingly looking to sell out of triple-C rated assets, and purchase notes rated double-B or higher up the stack. “And they don’t want to sell out of triple-C and pile into B-/B3,” he said. “That can turn into a triple-C spike in a downturn.

The churn in lower-rated loans reflects a continued volatility in the loan market, as previously unexpected rate cuts have made the floating-rate loans less attractive to investors. Loan prices were down 0.22% in August, according to JPMorgan, as the share of loans trading at or below par of 98 cents on the dollar has risen to 32.47% of the secondary market.

Retail loan funds continue nearly 40-week exodus trend from the market totaling more than $47 billion. Money-market and exchange-traded funds that used to hold 20% of the loan collateral have shrank their loan assets to just 8% of the outstanding market, according to JPMorgan. (Loan funds are averaging withdrawals of $606 million a week in 2019, according to Lipper data.)

Buoying the market, of course, are CLOs.

CLOs are still capturing enough of the the new-issue supply of loans in the market to continue supporting near record-level volume of loan portfolios this year. CLOs also “are providing a relatively steady bid for secondary with CLO ex-refi/resets totaling $82.6bn in 2019 only down 12.3% [year over year] from record levels,” according to a Sept. 4 JPMorgan report.

Spreads in CLOs, while having widened compared to 2018, have also maintained constant levels across most tranches, with AAA-rated notes pricing in the basis point range of the "high 130s" over Libor, according to Deutsche Bank.

“The CLO equity arbitrage has improved in comparison to the first half of 2019 on the back of the marginally tighter liabilities and increased asset volatility,” said Kashyap Arora, structured credit portfolio manager at DFG Investment Advisers. “We could see more issuers come to the market and we expect the high pace of issuance to continue for the remainder of the year. We believe 2019 could mark another record year for CLO issuance.”

The loan market volatility, according Arora, “will favor CLO equity, given that CLOs are structured to take advantage of volatility. However, not all CLO equity is created equal and it is important to be invested in the right structures with the right managers.”

Merrill noted weighted average spreads have “ticked up” in recent deals, indicating managers are buying lower-yielding loans, which cut into the arbitrage between what they pay to investors and receive in quarterly loan proceeds.

The level of concern for loans suddenly turning sour sparked an early August Wells Fargo report that focused on six large “one-off” loans that sank into distressed status. Electronics refurbisher 4L Technologies (d/b/a Clover Technologies), for example, saw a three-notch drop in its corporate debt rating to Caa3 from B3 in July after lowering earnings guidance from the loss of business with AT&T, a key client. Clover’s $760 million senior first-lien loan (also rated Caa3) has a 4 basis point (0.04%) exposure across 132 U.S. CLOs, according to Wells Fargo analyst Dave Preston.

Diversity level scores of CLOs are declining, as well. Normally, higher diversity scores show managers are limiting concentration risks in sectors and the number of obligors. But the scores could be declining as “CLO managers start to avoid certain sectors as they prepare for the next downturn,” Merrill said.

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