April 17, 2020 / 1:56 PM / 4 months ago

CLO issuance falls 48% as rush of loan downgrades threatens investor distributions

NEW YORK, April 17 (LPC) - Issuance of US Collateralized Loan Obligations (CLOs) fell 48% in the first quarter as the coronavirus pandemic shut down global economies leading to a rush of loan downgrades that could cut off distributions to the fund’s most junior investors.

More than 140 companies, including 24 Hour Fitness and YRC Worldwide, have been downgraded to Caa1 or lower from Moody’s Investors Service or CCC+ or lower from S&P Global Ratings. The ratings dropped from a single B rating between February 20 and Wednesday, according to data compiled by Refinitiv LPC. A Caa1/CCC+ grade is just a few steps above default.

Defaults and a significant number of loans rated CCC can trigger tests within the CLO and cut off distributions to equity holders.

Analysts are saying payments could stop as soon as this month.

The US$680bn US CLO market is the biggest buyer in the US$1.2trn US leveraged loan market, which companies including American Airlines and Hilton Worldwide rely on to fund their operations and back mergers and acquisitions. Fewer funds can make it harder and more expensive for businesses to access capital.

CLO issuance plummeted as the health crisis interrupted supply chains, closed retail operations, and reduced consumer demand, pushing the world economy toward a recession.

Fitch Ratings expects a 5%-6% default rate for loans this year and 8%-9% of loan defaults in 2021. The leveraged loan default rate ended February at 2.1%.

“Downgrades are the biggest focus in the CLO market, with managers worried about tripping their junior overcollateralization (OC) test,” said Sean Solis, a partner at law firm Milbank. “There has been a lot of focus on managing the structure, and it’s hard because there can be such an abundance of CCC loans in a deal.”

Downgrades to CCC in the underlying loan pools create the risk of an OC failure, which, coupled with defaults, will lead to equity cash-flow diversion, according to Rishad Ahluwalia, head of CLO research at JP Morgan. He says the bank expects at least the majority of CLOs to fail junior tests over the second quarter.

FALLING VOLUME

There was just US$15.2bn of US CLO issuance in the first three months of the year compared to US$29.3bn during the same quarter in 2019, according to LPC Collateral data. US CLO issuance in March dropped to US$3.4bn, the lowest monthly tally since July 2013.

“The CLO market is frozen – the primary reasons are due to the impact of falling loan prices and the wave of downgrades we have seen as rating agencies rerate risk in this environment,” said Frank Ossino, a senior portfolio manager at Newfleet Asset Management.

The LPC 100, a cohort of the 100 most liquid US loans, fell more than 21% from the start of the year to an 11-year low on March 23 of 77.87 cents on the dollar. It has since rebounded to 91.84 cents Wednesday.

The market reopened, slightly, in April, after managers sought to take advantage of the disconnect to buy loans cheaply. Blackstone Group’s GSO Capital Partners issued a static CLO – the assets in the fund remain the same for the life of the deal – and Apollo Global Management’s Redding Ridge Asset Management priced a short-dated CLO, which allows the fund to be reworked after a year.

When new issuance stalled, CLO investors turned to the secondary market.

For the first three weeks of March, one of the better opportunities in CLO debt investing was buying A and BBB tranches at discounts in the secondary market, according to John Wright, head of Bain Capital Credit’s CLO structured products business.

“Even though there was a high degree of uncertainty, those tranches are so well insulated, you could run a severe stress scenario and still end up with a good recovery,” he said.

As loan prices have recovered on the back of the federal stimulus and the price of CLO debt has improved, Bain Capital Credit is still constructive on BBB CLO debt.

“Given the environment we are in, it’s difficult to make a broad-based generic recommendation on parts of a capital structure, but BBB is a sweet spot with bonds trading in the 70s or low 80s and still have very good insulation of what is likely to occur on the default side,” Wright said.

While several CLOs are said to be in the works, the market still faces more loan downgrades and defaults.

“There is a payment date in April, and we are starting to get those monthly reports that will include the carnage of March, and we are starting to hear of some funds tripping their OC tests,” said Newfleet’s Ossino. “Hard to see the market fully reopen when CLO equity investors are not getting full repayments.” (Reporting by Kristen Haunss; Editing by Michelle Sierra)

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