Credit Risk Trends for CLO Issuers

CLOs becoming a victim of their own success? 🥹 I used to be a big buyer of CLO tranches back in the 2000s. An asset class I am super familiar with and which I like to follow for the opportunity set that CLO equity funds represent. Bloomberg is highlighting an interesting, somewhat disconcerting trend in CLO land which warrants a closer look 👀 in my view: "The $1.3 trillion CLO market is about to become a victim of its own success because managers can’t create the bonds fast enough to meet demand and are running out of things to buy. A slowdown in M&A after borrowing costs rose is continuing to deprive the lenders of the leveraged loans that the industry was built on. About $311 billion of M&A deals have been announced and completed so far this year, roughly $1 trillion below the same level two years ago when interest rates began to rise. 💡That may soon end up impacting the equity arbitrage which may hurt new issuance in the coming months. It’s also sent more managers into the secondary market, where about 60% of loans now trade above par, making it that much harder to find bargains to put together a portfolio. 💼 'There’s too much demand for CLO bonds and too little loan supply. CLO managers can’t keep up much longer,' said Pratik Gupta, who leads CLO research at Bank of America. Demand for the safest CLO tranches soared this year after an influx of money into ETF. Banks have also been piling into the AAA bonds, and some Japanese 🇯🇵 institutions may scoop up more of the debt. On top of that, Bank of America estimates that about $64 billion of the debt has been paid back so far this year, including amortizations and called CLOs, meaning asset owners have more capital to put to work. 'If you’re an existing investor, you’re getting so much money in the door that’s creating demand in and of itself,' said Amir Vardi, an MD at UBS Asset Management. 'Forget about increasing the budget to get more,' he said on a panel. 'You’re just trying to keep what you have invested.' Demand is so strong that even an 86% increase so far this year in US sales of new issue CLO bonds from the same period in 2023 hasn’t been enough to sate investors’ appetite. As a result, spreads on the AAA debt have compressed by more than 100 basis points over the benchmark since late 2022. ⚠️ Lenders are also trying to circumvent the dearth of paper by increasing their holdings of corporate bonds — both investment-grade and junk — in an attempt to preserve arbitrage returns, Gupta said. The rise of private credit is also crimping opportunities for leveraged loan lenders by winning business from them. 'The supply and demand balance is out of whack, it’s become more difficult to find assets at attractive levels,' said Christina O’Hearn, PM for the leveraged loan and CLO business at Pretium Partners. 'We expect to see continued refi & reset activity but not as many new issue CLOs.'" (+++Opinions are my own. Not investment advice. Do your own research.+++)

Moody's Reports Stunning Drop in B3 coverage ratios Consistent with my recent posts, Moody's Investors Service’s recently reported a jaw dropping 50% plunge in interest coverage for B3 ratings. As shown in the chart below, Moody’s revealed a decline in interest coverage from 1.5 to 0.91 for B3 credits in 2023. When I published my series of CLO/Leveraged Loan articles, I noted that the B3 credit was one of the largest CLO rating buckets at around 30% of the total. An interest coverage ratio less than one would seem would seem to justify Caa/CCC ratings, not a B handle rating. Under Moody’s Weighted Average Rating Factor (WARF), the default probability for a B3 that falls to a Caa1 increases from around 38% to 48%. This should, at a minimum, lead to material downgrades across the CLO rating spectrum all the way up to Aaa/AAA. It should. But it likely won’t. If the ratings agencies are consistent in applying their ratings models it would seem logical that such a large drop in interest coverage would lead to a large reduction in ratings in the underlying loans followed by a drop in CLO ratings (the CLO raters likely would wait until the underlying loans were downgraded). This chart focuses only on the B3 rating. Mathematically it's a dead cert that the remaining spec grade ratings experienced a similar nosedive in interest coverage. As the average underlying loan rating moves down from mid Single-B to low single-B/CCC and recoveries drop sharply, AAA ratings become untenable. Side note: It's pretty clear from Moody's analysis that leveraged loan borrowers were doing about as much hedging as the banks were doing on their long duration securities (i.e. very little). Moreover, along with recently reported large declines in defaulted loan recovery rates, the inputs to the rating agency models should be flashing red. If they are not now, they will soon. However, experience shows us there is a long lead time between the rating agency models flashing red and actual rating action. A wave of downgrades could be on the horizon. With well over $100B in AAA CLOs at three of the largest US banks alone (Wells Fargo, Citi and JPMorgan Chase & Co.) should such downgrades materialize, it could wreak havoc with bank earnings and capital. Insurance companies also own a material amount of CLOs, generally further down the capital structure (eg Single A/BBB).   It's important to note that Moody’s interest coverage analysis uses earnings from year-end 2022 and therefore the deterioration in coverage appears to be entirely due to rate increases. i.e. it doesn’t take account of any non-interest deterioration in cashflow. #banking #leveragedfinance #privateequity #capitalmarkets #federalreserve #fdic

CLOs are Cracking: Welcome to the World of Unintended Consequences A big selloff of existing collateralized loan obligations (CLOs), which buy and pool buyout debt, has slowed the issuance of new CLOs. This makes sense - because the selloff pushed down the prices of existing CLOs, that's what investors will buy until issuers price new CLOs more attractively. This in turn has created a headache for banks looking to offload buyout debt they would have gotten off of their balance sheets by repackaging it into new CLOs. This is not a minor issue; CLOs are a ~$1.4 trillion market. Part of the pressure the market is under is by design. CLOs typically pay floating rates, so they yield less when rates look like they might fall faster than previously believed. And because they are backed by debt used to help finance leveraged buyouts, they also have exposure to credit risk. You're seeing the heightened market pressure show up in ETFs that own CLOs. The $20 BN Janus Henderson AAA CLO ETF (JAAA) recently saw nearly $600 MM of withdrawals, the biggest single-day outflow since the fund’s inception in 2020. This alone was enough to put pressure on valuations overall. ETF prices normally trade in line with net-asset values because specialized traders (aka, "authorized participants" / APs) will buy shares of the ETF whenever they drop below the NAV because they can then redeem the ETF with the issuer in exchange for the underlying assets, which they then sell. It's essentially a risk-free profit. But some CLO-focused ETFs are trading at discounts to the value of their portfolios wider than 4%. The fact that the APs are not stepping in to pick up what should be free money makes us wonder how accurate those NAVs are. As the macro environment continues to deteriorate, and at an accelerating rate, the banks looking to offload the loans they made via new CLOs must be going through the same grim math. Needless to say, when even the specialists hesitate to step in, buyer beware... For the full picture, read these very thorough articles by Carmen Arroyo Nieto, Scott Carpenter, and Katie Greifeld: https://lnkd.in/eWBV527F https://lnkd.in/eiFA73Bx #investing #stocks #bonds #CLOs #ETF #stockmarketcrash #tariffs #TradeWar

We have been discussing within the team an increasing disconnect between the leveraged loan market and lower mezzanine CLO tranches, as shown in the chart below. Loan bid prices have been drifting lower, while BB CLO discount margins continue to tighten. In our view, this divergence is primarily driven by technical factors rather than changes in underlying fundamentals. The tightening in mezzanine tranches reflects strong demand for cleaner collateral profiles and higher average prices. That demand has compressed spreads and extended effective duration, even as loan market pricing softens. This dynamic was also discussed in our latest In the Tranches (30 January), where we highlighted the tightening of mezzanine CLO risk despite weaker signals from the underlying loan market. The chart shows CLO BB discount margins (blue) from Citi Velocity and bid prices on leveraged loans (inverted, orange) from Bloomberg over the last five years. Hat-tip: Mathias Vikner, Tiberio Carboni , Lasse Gorm Nielsen #inthetranches #clo #leveragedfinance

The biggest buyers of leveraged loans are getting pushed to the sidelines, which is set to make it harder for riskier companies to tap the $1.4 trillion market for such debt. Money managers are poised to dramatically slow new issuance of collateralized loan obligations, which buy and pool buyout debt, in the coming weeks, according to Goldman Sachs Group Inc. and Morgan Stanley analysts. That’s because a large selloff of such securities has enticed investors to buy what’s already out there and pressured CLO issuers to ramp up pricing. Auctions for CLO securities, known as bids wanted in competition, jumped to $3.53 billion last week, the highest volume in a single week since at least 2019, according to data from Bank of America Corp. w/ Scott Carpenter Isabella Farr https://lnkd.in/e-3ptW3h