When compared to the ABS CDO market, the CLO market has remained relatively intact, despite the liquidity dry-up in the corporate credit market this past summer and heightened concern about subprime RMBS contagion. But while new issuance appears to be picking up, an expected increase in corporate defaults could create future complications for these vehicles.
Standard & Poor's predicts that default rates will escalate over the next year based on changes in the credit-pricing environment and a slowing of the economy, as well as a rating mix with a "record high representation of speculative-grade ratings,"the rating agency said in a recent report.
Indeed, there has been an increase in lower quality issuance, particularly in the CCC' rating category, according to panelists at the IMN's ABS East Conference in Orlando last week. They also emphasized that, up until recently, many deals hitting the leveraged loan market had been short on covenants.
Despite the fact that CLO managers rely less on the rating of a transaction and do more due diligence, corporate defaults will hurt CLOs, said panelist Brian McManus, head of CDO Research at Wachovia Capital Markets.
Also adding to concerns about defaults is the fact that many deals have more loans than bonds in the capital structure, which means less subordination of debt, panelists noted.
As of October, the 12-month trailing default rate was at 0.55%, based on the number of issuers. While there is little default pressure expected in the next three to six months, it is beginning to mount for 2008, S&P's report said. The loan default rate, by number of issuers, is anticipated to be 3.10% by September 2008.
Defaults will also increase as the result of consumer reaction to housing and oil prices, among other factors, said panelist Dan Smith, managing director at GSO Capital Partners. Furthermore, consumer spending is expected to slow to 2.2% year over year by the end of 2008 from 3.4% in the third quarter of 2007, which should restrain corporate profit growth in consumer discretionary sectors, S&P said.
Smith also noted concern in the health-care sector, which has issued a significant amount of CLO collateral, including billion-dollar transactions from HCA, Health Management Associates and Community Health Systems. With governmental change nearing, and health care a primary policy focus, reimbursement risk is a growing concern, Smith said, adding that his firm was looking to minimize its exposure to health care.
CLOs Not CDOs
Despite the impending rise in loan defaults, market participants don't think the CLO market will be affected in the same way that rising RMBS delinquencies have halted the ABS CDO market. Though loan default rates are likely to rise, probably in late 2008 and 2009, they will not rise to elevated levels, JPMorgan analysts said in a report. "Loan security [higher up in the capital structure] and CLO structural support should help protect debtholders."
CLOs are also having problems selling triple-A tranches, which is especially problematic because 70% to 80% of CLO funding is triple-A, ABS East panelists agreed. Traditionally, CDOs squared, banks and SIVs were buyers of these tranches, but that demand has diminished. "The senior portion of the capital structure remains the bottleneck, and AAA's feel somewhat weaker on continued noise surrounding SIVs and monolines, which were large buyers of senior structured product assets," JPMorgan said. There are also more sellers than buyers now in the market, with SIVs unloading many of their assets, panelists noted, and bank funding costs have also risen.
The Deals Go On
Despite market jitters, CLO issuance is persevering with structures expected to hit the market in the form of legacy-warehouse facilities, total-return-swap CLOs, market-value CLOs and LCDS structures, Tania Fago, a senior director at Derivative Fitch, said at the conference. JPMorgan added that tranched LCDX may be a substitute for CLO investments. Though tranched LCDX is an unrated vehicle, investors can fairly easily obtain it in rated and credit-linked note format, the bank said.
Fitch's Fago also predicted the CLO market would be smaller because of a move to more traditional real money investors, who can only buy smaller CLO buckets.
Eduardo Piedra, a portfolio manager at Baker Street Asset Management, added that some of the more recent stand-alone CDO managers might not be able to last during the slowdown, emphasizing the broad market expectation for manager consolidation. "It will be a smaller pond with less fish,"Piedra said.
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