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Clear signals to go higher in capital structure

| January 4, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

A nearly 5-point drop in the price of the average leveraged loan since September has cut the liquidation value of nearly all CLOs. And even though CLO debt does not rely on market value for repayment, debt pricing should reflect the thinning value of deal equity. Spreads have widened sufficiently across ‘A’ and higher rating classes, but ‘BBB’ and lower classes have not widened enough. It’s a clear signal to go higher in the capital structure.

Falling loan prices raise asset leverage

The price of the average leveraged loan has fallen from $98.61 at the end of September to $93.82 at the close of December, a 4.8% drop. The drop has raised the market value leverage of all CLO classes—by a small amount in higher rated classes and by an eye-opening amount in lower rated classes. An example helps make the point.

Credit Suisse Asset Management priced Madison Park XXIX in late September, raising $744 million in debt and $56 million in equity to buy $800 million in leveraged loans (Exhibit 1). After issuing the ‘AAA’ through ‘B’ debt, the CLO was 14.29 times leveraged–$56 million in equity controlling an estimated $800 million in assets, or $1 of equity for every $14.29 in assets. If the manager had only issued ‘AAA’ through ‘BB’ debt, the CLO would be 11.76 times leveraged–$68 million in equity controlling $800 million in assets. Issuing only ‘AAA’ through ‘BBB’ debt would trim leverage to 8.16 times and so on until issuing only ‘AAA’ debt would bring leverage down to 2.33 times. Deal leverage after issuing down to each rating class is useful for looking at fair value across classes.

Exhibit 1: Analysis of Madison Park XXIX

Note: Market value at 9/28/18 assumes the manager purchased all loans in the deal at par. Market value at 12/31/18 assumes that the loans traded in line with the 4.8% decline in the average leveraged loan. Source: S&P, APS

Credit investors should get compensation for each turn of leverage in the company or structure issuing debt—reward for the risk that a drop in asset value could leave the issuer insolvent, or, in a CLO, vulnerable to default. In fact, in pricing Madison Park XXIX, the discount margin rises in line with leverage from 114 bp in the ‘AAA’ to 790 bp in the ‘B’. The discount margin for each turn of leverage varies between 37 bp and 55 bp.

As loan prices dropped through the end of December, however, things changed significantly. An estimated $38.4 million drop in loan market value meant the deal had only $17.6 million in equity value left supporting $761.6 million in asset value, or 43.27 times leverage. That is more than triple the market value leverage at new issue. The leverage created by issuing down to ‘BB’ had more than doubled to 24.73 times. The leverage from issuing only ‘AAA’, however, had only marginally moved higher.

Discount margins have priced in leverage in higher classes, not in lower

Discount margins have widened since late September by enough to cover the additional leverage in higher rated classes but not by enough to cover the lower rated classes. Margin for each turn of leverage has improved by 14% to 19% in ‘AAA’ through ‘A’ classes while actually declining in ‘BBB’ and below. In other words, investors in ‘BBB’ and lower rated classes today get paid less per turn of leverage than they did in late September. Risk-reward looks much better in the higher rated classes.

Investors should sell lower rated classes to buy higher rated parts of the capital structure. Investors reluctant to give up the income from the lower rated classes would be better off buying the higher rated classes and using repo to enhance net income.

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