The collateralized loan obligation (CLO) market’s exuberant recovery from its pandemic doldrums of 2020 appears likely to continue, although credit risk is nudging upward and the market recently saw its first defaults of post-financial crisis transactions.
S&P Global noted in its “U.S. CLO and Leveraged Finance Quarterly Key Themes, Q3 2021” that CLO new issuance through Q2 2021 totaled $82.3 billion compared to $91.7 billion for all of 2020, while CLO resets and refinancings (refis) totaled $126.6 billion compared to $33.6 4 billion for all of last year.
The high CLO volume this year stems partly from transactions whose refis or resets anticipated last year were deferred when spreads widened considerably as the pandemic unfolded, and from transactions completed last year that now seek to refinance at more attractive pricing. Daniel Hu, an analyst at S&P Global, said that currently tight spreads, even lower than those pre-pandemic, have resulted in a backlog of potentially callable deals.
“What’s gotten done so far is still a fraction of what’s callable out there,” Hu said. “So the number of deals going ahead is probably limited to how much volume the market can handle.”
Robust leveraged loans and 'B-' Issuers
A currently robust leveraged loan market also supports the active CLO market. Moody’s Investors Service said in a CLO sector update on August 17 that “idealized credit conditions” have prompted leveraged finance market activity “exceeding a typical mid-summer pace.” The borrower-friendly conditions, including low default expectations driving private equity deals and higher leverage multiples, Moody’s said, have resulted in continued lower credit ratings at issuance.
“Looking to September, we believe a fresh round of deal activity will be sustainable thanks to CLO and mutual fund expansion, among other investors,” Moody’s said.
S&P Global reported that at the end of Q2 2021 loans rated ‘B-’ make up the largest portion of speculative-grade debt in CLOs, at 27%, compared to 20% at the end of 2019 and less than 13% at year-end 2017. That increase partially reflects upgrades from the ‘CCC’ category, the rating agency noted, but ‘B-’ has also become the most common rating among new-issue CLOs since Q4 2020, reaching a record in Q2 2021.
Moody’s says that despite lower credit ratings on loans underpinning existing CLOs, their interest coverage is still better than it was before 2007, before the emergence of the so-called CLO 2.0 vintage. That cohort began to provide investors with stronger terms. Driven by stronger-than-average free cash flow, new loans’ debt-to-EBITDA numbers actually fell in Q2, the rating agency said. Moody’s added that “such ideal circumstances are subject to change, and we expect ratios to rise again over the longer period due to aggressive transactions coming to market and weaker future cashflows.”
Alleviating future pressures
Higher ratios of debt-to-EBITDA could put pressure on CLOs in the event of another downturn, eventually. However, the highly structured transactions, in which equity investors absorb much of the risk, have so far performed well through periods of financial stress. Among the 4,322 ratings of tranches in the 800 cash-flow CLOs making up the 1.0 vintage, starting in the mid-1990s through 2009, just 40 have defaulted, said S&P Global in its “CLO Spotlight” report, published August 18. Transactions in the 2.0 vintage since then have been structured with stronger terms, including more credit enhancement for rated CLO notes, and excluding investments in assets other than corporate loans, and had avoided any defaults until recently.
That changed when the Mountain Hawk II and Flagship VII CLOs each had tranches that defaulted earlier this year, S&P Global reported. In seven other CLO 2.0s, the rating agency said, there are three tranches currently rated ‘CCC-’ and another six now rated ‘CC’ that are likely to default. Even so, the problematic CLOs are limited so far to earlier 2.0 deals that experienced both the energy and commodity downturns in 2015 and 2016 and later the crisis brought on by the pandemic. The $517 million Mountain Hawk II deal, for example, priced in June 2013, and its $21 million tranche E was originally rated BB. That tranche experienced collateral deterioration that led to its default, according to S&P Global.
“So far, only a modest number of U.S. CLO tranches are expected to default coming out of the 2020 economic downturn, mostly limited to the junior-most tranches within the capital structure of the CLO,” S&P Global said.
