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NEW YORK Downgrades to energy companies' credit ratings are weighing on Collateralized Loan Obligations (CLO) funds' portfolios, in another hit to a market already facing a drop of more than 50% in issuance this year.
The credit quality of CLO assets is deteriorating, according to a report by Standard & Poor’s, which downgraded 45 energy borrowers this month as oil prices remain around all-time lows.
The credit ratings of around 1.4% of assets held by US CLOs have been downgraded or placed on credit watch with negative implications this year.
CLO volume is already forecast to more than halve to US$45bn this year due to market volatility and impending regulation that will force firms to hold 5% of their deals.
Lower issuance of CLOs, the main buyers of leveraged loans, may make it harder for companies to issue new debt in the already-challenged US$870bn US leveraged loan market, which provides non-investment grade financing to companies including retailer Dollar Tree.
CLOs are typically allowed to hold around 7.5% of loans with ratings of Caa1/CCC+ or lower, according to Deutsche Bank, which makes mass credit downgrades difficult for some managers. About 15% of funds have lower limits of 5%.
When low-rated loans exceed those limits, CLOs get a haircut in overcollateralization (OC) tests, which mean that the loans may have to be marked down to market value rather than par or face value. The test measures the value of funds' assets compared to its debt and if CLOs fail, interest proceeds are used to repay debt investors.
CLOs pool loans of different credit quality and sell slices of the fund of varying seniority, from Triple A to B, to investors such as insurance companies. The equity slice, the most junior and riskiest part of the fund, is paid last after bondholders.
Two hundred and nine US CLOs issued since the credit crisis have an average exposure of 0.69% to one or more of the 45 companies downgraded by S&P, according to the ratings firm.
Fieldwood Energy is held by 140 CLOs and had its corporate credit rating cut to CCC from B. Templar Energy is held by 72 funds and had its rating cut to CCC- from B-.
“A number of names have been lowered to the CCC bucket, which could affect OC tests if the CCC thresholds are breached,” said Jimmy Kobylinski, an S&P analyst.
The number of downgrades may continue to increase. The number of companies with a low B3 rating and a negative outlook or lower rose to 264 as of February 1, just 27 issuers below an all-time high in April 2009, according to a February 3 note from Moody’s. Oil and gas borrowers make up 28% of the list.
The growing list, formerly known as the “Bottom Rung,” shows deteriorating credit quality and points to a rising default rate in 2016, Moody’s analysts said. The ratings firm is expecting the US speculative-grade default rate to rise to 4.5% in 2016.
Heavy energy exposure is also starting to weigh on CLO ratings. A tranche of a post-crisis CLO was downgraded last month when S&P cut the Class E notes of Silvermine Capital Management’s ECP 2013-5 to B- from B. Analysts said that the fund had credit deterioration in the collateral portfolio and a large exposure to the energy sector.
“People are definitely trying to get their heads around what [increased CCC holdings] says about the credit cycle,” said Chris Flanagan, head of US mortgage and structured finance research at Bank of America Merrill Lynch in New York. “The market has changed dramatically in just six weeks.”
(Editing By Tessa Walsh and Jon Methven)