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Rising loan risk
admin | October 11, 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.
CLOs have struggled to keep up with other fixed income credits since 2017 arguably because of rising risk in the underlying leveraged loans, and this year has been no different. The share of loans rated ‘B+’ or lower continues to climb and the CLO market is having trouble absorbing the supply.
The share of leveraged loans hanging onto the lowest performing rungs of the rating ladder has climbed since 2017 and accelerated again just since June (Exhibit 1). The share of loans with a ‘B+’ or lower rating has run from 54% at the start of 2017 to 65% at the end of September. Since June alone, the share has moved up three percentage points.
Exhibit 1: Continuing ratings weakness in outstanding leveraged loans
Source: LCD
CLOs this year have bought 72% of institutional issuance, the highest share ever, and the incidence of ‘B+’ and lower ratings is adding to risk in the market. The short distance to ‘CCC’ and the typical 7.5% limit on CLO exposure to that rating class adds to the risk of failing overcollateralization tests and consequently diverting principal cash flow to pay down the balance of the CLO ‘AAA’ debt. Equity gets hurt, and ‘AAA’ investors get accelerated.
The risk from ‘B+’ and lower loans looks like it is driving up the appeal and the price of ‘BB-‘ and higher loans. Spreads on ‘BB’ or ‘BB-‘ loans have tightened by 51 bp since late July and 24 bp in September alone (Exhibit 2). Spreads on ‘B+’ or ‘B’ loans, meanwhile, have widened by 50 bp since late July and by 8 bp in September. That pattern seems at least consistent with a CLO bid that see particular risk in ‘B’ loans and particular value in ‘BB’ loans that could take a notch of downgrade without triggering a change in a structure’s cash flows.
Exhibit 2: ‘BB/BB-‘ spreads tighten while ‘B/B+’ go wider
Source: LCD
The persistent softness of the averaged leveraged loan price may partly reflect the shifting credit mix (Exhibit 3). The recent accelerated drop in loan prices also leaves a rising share of loans trading at spreads wide to their current rating. The market-implied rating of leveraged loans is falling. The CLO market has reasons to be nervous.
Exhibit 3: A drop in leverage loan prices has accelerated lately
Source: Bloomberg, S&P
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