With CLO managers ramping up funds in record numbers, investors have been scrambling to cash in on the diverse investment strategies that make these vehicles a safe choice for yield. However, a recent survey from Fitch Ratings found that these funds may not be as diversified and low risk as their definition would suggest. In fact, CLOs as a whole have been acquiring a high proportion of leveraged loans that are used to fund "shareholder friendly-activities," as well as loans that are light on covenants, and this could mean very unsteady investment platform in the event of a downturn.
Shareholder friendly-activities include leveraged buyouts, mergers and acquisitions and dividend payment capitalizations - activities that Fitch considers potentially riskier transactions than the more benign refinancing. "One of the benefits of the CLO structure is risk reduction, achieved primarily through diversification and overcollateralization. A concentration in shareholder-friendly loans raises the issue of the potential impact on the diversification benefits of the CLO structure," John Schiavetta, group managing director at Derivative Fitch, said in a release.
And with volume at an all time high, not only do many of these CLOs appear to be unbalanced, but they also cultivate some shaky investment ground. "Leveraged loan issuance has soared over the past several years, and it is well known that heated demand for loans, among CLOs in particular, has had a profound impact ... by enabling increasingly riskier deals to come to market, including those supporting LBOs and other shareholder-oriented transactions," said Mariarosa Verde, managing director, credit market research at Fitch.
During the first-quarter 2004 to third-quarter 2006 period studied, the loans used to finance LBOs appeared to have modest spread premiums at both single-B and double-B risk levels compared to the overall market, according to Fitch. And since so many huge LBO deals have come to market of late, it's not surprise that these issuances would make up a large or disproportionate share of a given CLO's investment pool. Larger deals usually provide for bigger allocations, as well as enhanced secondary market liquidity, factors that may be very attractive to CLO managers, the rating agency said.
And the trend does not seem to be tapering off in the near future as the market expects a plethora of buyouts to come. "As long as the credit environment remains robust, shareholder friendly transactions are sure to continue and CLOs will very likely continue to have a disproportionate share of these loans," Verde said.
Heavy focus on lite deals
At the same time, many loans found in CLOs also have fewer covenants. Indeed, 30% of the single-B loans found in the CLO sample studied contained three or fewer covenants, versus 21% in the overall market.
Given the incredibly liquid market, borrowers have been able to get increasingly flexible terms causing covenant packages to deteriorate over the past several years. Subsequently, the ability to align a borrower's actions with the interests of lenders has diminished, along with the early warning system for a borrower's financial distress. This is not entirely new to the leveraged loan market. However, the fact that CLOs are holding increasingly large numbers of covenant-lite loans could mean an increased probability of trouble for them in the future, according to Fitch.
While loans financing LBOs offer a modest spread premium for higher yield (all else being equal), the covenant-lite deals also likely offer a moderate pick-up in yield to compensate for the weaker covenants, Verde said. While she did not think it was surprising that CLOs would favor higher yielding assets, the concentrations further emphasized the issue of diversification within the CLO structure, as the vehicles appear to be putting the bulk of their investments in certain risky baskets.
Fitch examined approximately 600 rated leveraged loans issued between Jan. 1, 2004, and Sept. 30, 2006, which were held by 91 CLOs. The loan data is a combination of loans contained in Fitch-rated and other agency rated CLOs tracked by Reuters LPC CLOi Service.
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