CLO managers are starting to see the positive side affects of the recent rally in the leveraged loan market, as various CLO fundamentals improve. A somewhat surprising phenomenon, considering the market continues to face rising defaults and a still sluggish economy.
CLOs are seeing improvement by three principle measures: overcollateralization tests, triple-C basket levels and WARF “weighted average rating factor” ratios, which are used to asses the underlying credit quality of assets in a structured vehicle.
The CLO market began to experience a comeback late last month when the average price on the secondary surged past 90 cents. But now improvements can be seen across these various metrics.
Over July and most of August, the percentage of CLOs failing their OC tests decreased to 7% from 9%, while the percentage of CLOs failing their single-A OC test decreased to 21% from 25%, according to Citigroup.
Meanwhile, the average triple-C loan bid is now in the low 80s, more than double the historic low of 35.8 reached on March 19, 2009, according to Wells Fargo. The average double-B-rated loan is at 94.9, the highest levels since the beginning of 2008.
There is more evidence to show that CLO structures are improving. Over the past several months, the percentage of assets with a rating between Ca and Caa1 has dropped by more than 60%, according to the analysts at Wells Fargo. Roughly 15% of all CLOs are rated triple-C. The percentage of assets with a B3 rating have also fallen to 11.7% from 13.3% since mid-April.
And all of this has happened in an environment of rising defaults. Corporate default totals already exceed those of last year. Through Aug. 12, 201 rated companies defaulted, affecting $453 billion in debt, according to Standard & Poor’s. In all of 2008, 126 companies defaulted, affecting debt worth $433 billion. The 12-month trailing global corporate speculative-grade bond default rate increased to 8.58% in July from 8.25% in June. The default rate within U.S. CLOs, however, has remained flat over the past two months at 5.9%.
With loans trading at higher levels, CLO managers have been incited to trade more. This week, more than $600 million in BWICs — bids wanted in competition — across all ratings categories was traded between CLO managers, making this week the busiest week in “recent history” of CLO secondary trading, analysts at Citi said. The two weeks prior only saw roughly $50 million of CLO BWICs trade.
Since the rally began CLO managers have been working on ways to “build par,” or pick good credits that could go up in value. “[CLO managers] have sold triple-Cs as those prices rose and bought better-rated loans — a technique which further enhances collateral values,” Randy Schwimmer, the head of capital markets at Churchill Financial, said in a weekly email to clients. “Also helpful has been the slowing of loan rating downgrades. That has given CLO managers the time and tools to repair their vehicles.”
Consequently, CLO spreads have come down significantly over the last few months. Spreads for triple-A-rated tranches have fallen to Libor plus 450 bps from Libor plus 600 bps in May. That, however, is not as low as the level this time last year, which was around Libor plus 375 basis points.
“What no one knows yet is whether this will help new CLO formation. But it couldn’t hurt,” Schwimmer said.
Not everyone is convinced the CLO rally will continue. “While the overall market sentiment may be optimistic, there are idiosyncratic risks that are difficult to model or predict,” Wells Fargo analysts said. “The doubts are based on a belief that the fundamentals, while improving, may not justify the prices, as well as the theory that the rating agencies could still surprise investors with large-scale loan or tranche downgrades.” However, the risks are not just limited to the rating agencies, but also include the managers themselves, they added. “Controlling investors may feel a need to sternly push back on actions that damage the senior tranche positions, which would harm junior note holders.”
CLOs today only make up 28% of the institutional loan market, according to S&P Leveraged Commentary & Data. A year ago, CLOs made up around 41%.