Managers of 2.0-vintage CLOs are quickly increasing second-lien loan holdings to replace their shrinking bond exposure in the unsecured and subordinated strata of their collateralized loan obligation portfolios, according to an analysis from Moody’s Investors Service.
In a quarterly CLO review, Moody’s analysts Shan Lai and Jerry Gluck said CLO 2.0 bond holdings fell to $920.2 million in the first quarter of 2014, a $260 million drop from the second quarter of 2013. Meanwhile, second-lien loan holdings had a nearly corresponding increase of $250 million to $1.12 billion in the same period.
Managers were citing a near-record supply of 2013 second-lien loan issuance as well as volatile fixed-rate bond prices that produce market gains but also harbor interest-rate risk, according to Moody’s.
Surprisingly, the Volcker Rule was not considered a factor, although many structured credit watchers have blamed the regulatory ban on banks holding CLOs with bond investments as a reason for a brief halt in CLO issuance and trading earlier this year.
Lai and Gluck say the net swap of second-lien loan and bond holdings is not impacting the credit standing of these CLOs, since the ratings agency have found little difference in the prospective recovery rates of bonds and second-lien loans (The non-first-lien holdings in CLO instruments are typically only 5% to 10% of all assets).
“Although second-lien loans are senior to unsecured bonds when both exist in the same capital structure,” Lai and Gluck wrote, “most existing second-lien loans have no subordinate debt, and thus have the same priority claim on the collateral as do bonds.”
The report stated that the corporate second-lien debt recovery rate (approximately 25%) is already less than half its historical average of 52%, reflecting a “lack of unsecured debt subordinate to current second liens” and weaker covenant structured of speculative-grade loans.
Also noted was a “relatively stable” average weighted average recovery rate (WARR) across CLO 2.0s in that time frame, with WARR decreasing only 0.17 bps to 49.95% in the first quarter 2014 from 50.12% from second quarter 2013.
In examining 101 U.S.-based CLO 2.0 deals between the second quarter of 2013 and the first quarter of 2014, Moody’s found that bonds now account for 1.1% of aggregate par, while second-lien loans make up 2.3% of aggregate par.
CLO managers told Moody’s they have been driven by the increase in second-lien loan supply, which rose to a near-record $37.7 billion in 2013 (short of the $40 billion mark in 2007) and hit $8.5 billion in the first quarter (up from $7 billion year-over-year). “Investors, including CLO managers, are attracted to second-lien loans’ wider spreads compared with first-lien loans and can tolerate lower second-lien loan recovery rates, if defaults remain rare,” write Lai and Gluck.
Bond sales are attractive, according to Moody’s, because managers want to reduce the duration exposure of fixed-rate assets in an environment of potentially rising interest rates. They can also realize market gains that allow managers to build par which improves credit ratings.
“Since bond prices tend to be more volatile than those of floating-rate loans, managers can more easily build par by purchasing performing bonds below par and selling them above par,” the report stated. “Bonds purchased at prices as low as 80% of par still typically receive full par credit in CLO over-collateralization tests.”
Moody’s said managers it spoke with dismissed the Volcker Rule as reason for bond sales, since banks have been given extensions until July 2017 to bring their CLO holdings into compliance.