Sometimes, you have to rob Peter to pay Paul.

For the first time since the financial crisis, some collateralized loan obligations are being forced to divert funds normally used to pay junior noteholders to be used for the benefit of more senior noteholders.

CLOs, collectively the biggest investors in below-investment grade corporate loans, have a number of tests that they must meet each month that are designed to protect the quality of their portfolios. Some of the most common tests measure the amount of collateral supporting each class of notes issued by a CLO (interest diversion), the amount of assets supporting all of the notes, collectively, (overcollateralization) and the amount of interest available to pay notes (interest coverage).

If a CLO fails these tests, cash flows earmarked for holders of the most subordinated securities are used instead to purchase additional collateral. In some cases, the funds may be used to repay the principal of senior notes.

Two CLOs, Mountain Hawk II CLO and ECP CLO 2014-6, failed their interest diversion test for the April payment date, according to research published this week by Deutsche Bank. As a result the managers, Western Asset Management Co. and Silvermine Capital Management, respectively, diverted some cash flow from the most subordinated tranches of these deals, known as the equity, to be reinvested in new collateral.

Another deal managed by Silvermine, Silver Spring CLO, failed two tests, interest diversion and overcollateralization, causing payments to both the single-B rated tranche and the unrated equity tranche to be diverted to pay down principal on the most senior, triple-A rated tranche.

No surprise, all three deals have unusually heavy exposure to the oil & gas, metal and mining industries.  

Silver Spring CLO, issued in July 2014, has 15% of its portfolio invested in loans to energy companies and 4% in loans to metals and mining companies, according to Moody’s Investors Service. In February, Moody’s downgraded its ratings on $68.6 million of notes issued by the CLO, citing deterioration in the credit quality of its portfolio.

While the broader leveraged loan market has recovered some lost ground over the past two months from a steep selloff early in the year, a number of companies in these sectors have been downgraded or defaulted.

In April alone, three loans totaling $1.7 billion defaulted: Peabody Energy's filed for bankruptcy, Vertellus Specialty missed an interest payment, and Stallion Oilfield's conducted a distressed debt exchange. That pushed the trailing 12-month institutional leveraged loan default rate to 1.8% in April, up from 1.6% at end-March, according to Fitch Ratings.

When loans are downgrade too steeply or are in default, they can cause CLOs to trip coverage tests because managers can no longer value the loans at par.  

Ideally, diverting cash flows from junior noteholders to purchase additional collateral ultimately benefits all noteholders. That’s because CLOs generally fail these tests at times when loans prices are falling, allowing them to acquire new collateral at a discount. And unless these loans are considered to be deeply distressed (generally meaning they are trading below 80 cents on the dollar) the CLOs can value these new loans at face value, for the purposes of their tests. The end result is that all notes held by CLO investors are supported by more assets, and at a lower average cost.

But there just aren’t as many bargains as there were at the beginning of the year. Outside of energy, metals and mining, spreads, or risk premiums, on leveraged loans have narrowed considerably, over the past three months. Spreads on double-B rated loans have moved are currently at 383 basis points over one-month Libor, on average, 25 basis points less than they were one month ago and 75 basis points less than they were three months ago.

In other words, most of the really cheap loans are the ones that CLO managers probably don’t want to buy.

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