Prices on leveraged loans have suffered multiple record declines this week, as a month-long market sell-off unprecedented in intensity has ravaged secondary market values amid the economic stresses brought about by the coronavirus pandemic.
Of concern to U.S. CLO managers and investors is the potential accumulation of more lower-rated assets in their portfolios as defaults and downgrades mount in the loan sector.
On Wednesday, the JPMorgan Leveraged Loan Index declined $3.41 decline to an average loan price of $82.08 (per $100 par pricing) surpassed the prior all-time high $3.22 drop that had occurred on Monday. In all, the index has tumbled $15.38 since Feb. 21. Prior to this week, the record one-day fall had been the $2.46 decline registered on Oct. 10, 2008.
Among the hardest hit sectors for speculative-grade rated loans were the automotive sector (down $5.71), transportation ($5.07) and gaming/leisure ($4.28), according to JPMorgan’s daily high-yield and leveraged loan market report on Thursday.
For now, the drop in loan prices has limited impact on existing CLOs (held assets are not reset to market prices for ongoing coverage test purposes). However, observers say falling prices could be a harbinger of forthcoming defaults and downgrades that could affect managers' ability to meet ongoing coverage tests for their portfolios.
Still, junk-rated corporate borrowers that issue leveraged loans “may struggle with the acute cash flow shock brought about by the spread of the coronavirus, ultimately leading to an increase in default rates across sectors,” wrote Deutsche Bank analysts in a report issued Wednesday.
Such actions could trigger coverage test failures for required overcollateralization cushions (or the minimum par value of assets exceeding the notional value of issued notes) as well as the limit on so-called “triple-C” buckets in deals.
In a research report issued Monday by Wells Fargo, U.S. CLOs “still sport healthy coverage test cushions” with an average minimum collateralization spread of 394 basis points, as well as “low” percentage levels of near-default CCC or Caa (Moody’s Investors Service) ratings of 3.5%/3.7%.
CLOs are typically limited to 7.5% of total holdings in triple-C loans.
“We think CLOs would require at least a threefold increase in CCC exposure occur before the average CLO would breach its coverage test, given current CCC exposure and cushion levels,” wrote Wells analysts.
The collapse in broadly syndicated corporate loan prices since Feb. 21 is part of a broad-based sell-off of assets – not all of them risky - by nervous investors. According to Lipper, actively managed exchange-traded loan funds funds have had selloffs totaling $8.76 billion. The flight from high-yield bond funds totaled $16 billion in the same time frame.
The average 14.1% fall in loan prices in March exceeds the previous worst months that had been recorded in the midst of the 2008 financial crisis, according to JPMorgan. The $15.38 slide in prices since Feb. 21 is worse than the deepest seventeen day stretch of losses ($14.87) that occurred in the fall of 2008.
Spreads on the LL index’s three-year takeout have more than doubled to 1081 basis points as investor demand plummeted, compared to 452 basis points on Feb. 21.
According to JPMorgan, leveraged loans have year-to-date losses of 14.9%, with the lowest-rated tier of loans (split B/CCC rated) nearing a 20% loss on the year.
