As oil and gas prices continue to decline, concern is growing about CLOs with exposure to exploration/production and oilfield services companies.
This exposure is generally low; about one in six collateralized loan obligations rated by Moody’s Investors Service have exposures of 5% or more to drillers and oilfield services firms, with most firms averaging 2.69% exposure. Until recently, the impact was limited to holders of the most subordinate tranches of CLOs, which experienced losses in interest income and principal write downs when energy loans backing the deals were downgraded or defaulted.
But now so many energy companies are so deeply distressed that even the highest rated tranches of CLOs could be negatively impacted. Moody’s Investors Service this week issued a credit negative outlook for U.S. CLOs after placing 69 U.S. E&P and oilfield services companies under review for potential downgrades. It warned these actions could bring down the credit metrics for a wide swathe of CLOs, even if gas prices were to rebound.
U.S. CLO 2.0s were already considered to be “materially exposed” to the commodities industry beyond E&P and oilfield services, with Moody’s last fall reporting that 15% of them had exposure of more than 10% to gas, oil, metals and mining industry debt. But the “vast majority” had only “modest” exposure, and the CLOs with the largest exposures “mitigated” their higher risk by avoiding some of the oil and gas industry’s most risky firms.
In its latest report, Moody’s found seven CLOs with a 5%-plus exposure just to the 69 oil-and-gas companies being evaluated for downgrade (447 CLOs hold debt on these firms, with an average exposure of 1.55%). A CLO managed by Silvermine Capital Management has a 7.09% exposure to the companies being evaluated by Moody’s, with 6.29% exposed to those carrying rock-bottom junk grades of ‘Caa’ or below.
“Even assuming oil prices recover modestly from current levels, E&P companies and the OFS companies that support them will experience rising financial stress with much lower cash flows, which is credit negative for the collateralized loan obligations (CLOs) that hold their debt,” Moody’s reported this week.
CLOs issues notes and use the proceeds to acquire a portfolio of below investment grade corporate loans; interest from these loans is used to make interest payments on the notes; the most senior notes get paid first. But interest shortfalls, or even defaults, aren’t the only things that can impact noteholders. The deals are subject to a number of coverage tests, that, if not met, can trigger diversions of interest payments toward principal payments to maintain collateralization cushions and interest coverage ratios.
Several of the companies on the Moody’s list of potential downgrades are issuers of some of the most widely held debt in CLOs. ‘B2’-rated Seadrill Partners (with $838 million outstanding) and ‘B2’-rated Fieldwood Energy ($372 million) are in more than 200 portfolios apiece, and trade at extremely distressed prices.
The number of CLOs holding Seadrill and Fieldwood now is roughly the same as three months prior. Seadrill is still held by 241 CLOs, compared to 245 last fall, while Fieldwood’s CLO portfolio ties have grown from 257 to 261.
CLOs carry restrictions on the levels of ‘Caa’-rated debt they can hold, which means downgrades to corporate borrowers can easily elevate that total and trigger haircuts of excess interest to holders of the most subordinate notes, otherwise known as the equity. If more senior OC levels are triggered, then the interest for the most junior notes would be deferred and carry a deferred interest balance.
“Most deals start haircutting once the Caa bucket exceeds 7.5%,” said Moody’s analyst Min Xu in an interview.
CLOs can also run into trouble simply because the prices of loans in their portfolios fall in the secondary market, leading to trading losses and overcollateralization cushions of CLOs?
Downgrades also erode another metric known as the weighted average ratings factor, or “WARF,” a numerated calculation of the average debt ratings (‘A’, ‘BB’, ‘B’, ‘C’) of the underlying loans in the portfolio. A higher WARF indicates heightened risk. WARF figures rise as underlying assets accumulate lower corporate and liquidity ratings and the prices suffer further distress trading levels. While not directly impacting OC cushions or trading prices, a breach of a WARF covenant could limit a CLO’s trading flexibility by placing the onus on a new owner to improve the existing WARF.
WARF numbers for CLOs 2.0s and their underlying speculative-grade loans average 2765, or roughly the equivalent of a ‘B2’ Moody’s rating. Last October Moody’s reported that the average ratings factor for the E&P and oilfield services alone ranged from 4352 to 6686 for the 10 CLOs with the largest E&P and OFS exposures. Those figures equate to ‘Caa’-level ratings.
That highest WARF figure belonged to the Halcyon Loan Advisors Funding 2014-3, with has a 9.1% exposure to E&P and OFS companies.
Moody’s noted last October that GoldenTree Credit Opportunities 2012-1 Financing Ltd. breached its 15% ‘Caa’ holdings limit through downgrades of E&P and OFS credits.
For most of the past year, oil and gas-related debt have been considered a minimal problem for leveraged loans (comprising about 2 percent of the outstanding debt) and CLOs. Despite the “material impact” from commodities, Moody’s noted many CLO managers only raised the median commodity exposure to 6.6% as of June 2015, compared to 6.3% in January last year, with opportunistic purchases of commodities loans as secondary market prices slid.
But now Moody’s announced the wide-ranging review of the North American E&P and OFS sectors after it recently lowered its future oil price assumptions for 2016 and beyond. The price assumptions are crucial elements of an energy company’s corporate and liquidity ratings as well as in twice-annual lender “redetermination” reviews of their borrowing capacities.
Oil prices fell to under $28 a barrel Jan. 20 on both the West Texas Intermediate and international Brent Crude Oil price indices.
Moody’s first raised concerns of CLO’s E&P and oilfield services exposure last October, when the ratings agency reported that 15% of post-crisis U.S. CLO 2.0s had exposures of 5% or more on these firms.
At that time, Moody’s noted that the 499 CLOs with E&P and OFS exposure held $6.9 billion in such debt. Seix Investment Advisor’s Mountain View CLO 2014-1 Ltd. had the highest exposure at 10.6%.
Seix’ Mountain View CLO has a 5.57% exposure to the companies that were just placed on review for a downgrade, placing it behind four other CLOs that each have more than 5.75% exposure. Three of those CLOs are managed by Silvermine: Silvermore CLO Ltd., ECP CLO 2012-4 Ltd., and Silver Spring CLO Ltd.
In an investors roundtable discussion published this week by Standard & Poor’s, Prudential Fixed Income portfolio manager Edwin Wilches said that CLO notes buyers have been somewhat blindsided by the repricing of the “liquidity premium,” partially as a result of energy and commodities distress. “Some CLOs had more credit risk than investors may have realized or expected to have only a year or two after pricing,” he said, according to a transcript from S&P.
[Correction: An earleir version of this story misinterpreted the weighted average rating factor for CLOs with the highest exposures to exploration/production and oilfield services firms. The WARF figures reported between 4352 and 6686 were the average rating factors for the E&P/OFS portions of CLO exposure, not the pool of CLO deals as a whole.]