Will CLOs face a triple-C avalanche in a downturn?
There’s strong evidence that ratings on a significant portion of corporate debt will fall below the level tenable for many collateralized loan obligations, but they should nevertheless pass muster unless there is a broad and significant spike in downgrades.
That could happen. Ratings agencies have argued recently that the population of loans whose ratings fall below the lowest single-B rating – the lowest rung above the highly speculative triple-C ratings layers – will grow significantly in a downturn. (The lowest single-B ratings are B- for Fitch Ratings and S&P Global Ratings, and B3 on the Moody's Investors Service scale.)
“When the next credit cycle downturn comes, the proportion of Caa issuers could swell dramatically from today’s comparatively small 8% of the North America speculative-grade population,” noted Moody’s in a Sept. 5 report, referencing its version of the CCC rating from Fitch and S&P.
Moody’s goes on to note that most Caa/CCC corporate family ratings happen because of downgrades, so the biggest instigator will be the historically high concentration of B3/B issues.
“At 30% of the spec-grade population, the B3 group is now double that of the last recession and one-third of this group is B3 negative – those dangling closest to Caa,” Moody’s says. “At 30% of the spec-grade population, the B3 group is now double that of the last recession and one-third of this group is B3 negative – those dangling closest to Caa.”
John Nagykery, CLO team lead at Morningstar Credit Ratings, noted that CLOs traditionally are not market-value structures but instead are designed to naturally pay off investors. He said CLOs typically hold all their assets at par. When downgrades to assets within CLOs result in their CCC+ buckets exceeding the common 7.5% concentration limit, then the excess will be held at market value.
“If a large number of assets gets downgraded into CCC+, and their market values are low enough, a CLO can effectively breach one or more of its junior over-collateralization (OC) ratio tests,” Nagykery said.
Nagykery said that if downgrades were to trip a Class D OC test, the CLO would typically still pay interest on the Class D notes but not on any notes below. So interest on any Class E notes outstanding would be deferred, and so would subordinate management fees and equity distributions. As a result of the OC test breach the CLOs would then follow the note-payment sequence to pay down.
The CLO would then have some flexibility to reinvest in higher rated assets during the reinvestment period, as long as it is maintaining or improving those tests, Nagykery said.
“If the equity investors are not getting paid, they’re going to want to know how this happened and how it’s going to be fixed,” he said, adding that tripping the CCC bucket ultimately constrains managers somewhat on how they maintain or improve their asset mix.
Such downgrades do not force CLO managers to sell collateral, although some managers may choose pre-emptively to exit potentially problematic positions to avoid tripping tests. That activity, according to Bloomberg, has increased recently.
Nagykery said that a significant spike in defaults could be problematic for CLOs, but when the aggregate default rate spiked to upward of 12% in 2009, during the financial crisis, most managers reported much lower CLO default rates.
“Managers are paid to actively manage these transactions and avoid problem credits. So ideally the internal credit analysis already restricts investments in such collateral, and as a second layer of defense the manager should be able to pre-emptively get out of such collateral in the deal,” he said.
If a CLO does experience defaults, the outcome is similar to when CCC+ or lower-rated credits exceed the 7.5% limit, Nagykery said, adding the defaulted assets will be held at a the lower of recover rate or their market value. “So it will erode the OC cushion even faster, which will then trip more OC tests, and the CLO will again enter into corrective actions.
There is a scenario, however, that could upend CLO safeguards. Nagykery said that a “very big spike in downgrades or defaults—25% or 40% of the market—could impact CLOs” because their managers would likely hold similar credits, which would become very illiquid as CLOs rush to exit those positions, creating volatility.
“In nutshell, a mass exodus of confidence across different industries and sectors is what would be the main event to impact CLOs overall,” said Rohit Bharill, managing director and head of ABS at Morningstar. “With industry-specific downturns, CLOs are likely to be far better protected, because of the high diversity in their portfolios.”