Signs of stress in leveraged loans

| October 18, 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.

The price of the average leveraged loan has slowly drifted lower since early May before accelerating recently. With falling loans prices have come the first signs of distress in the most sensitive classes of CLOs. All of this comes as other US credit markets generally show strength. CLOs themselves, however, are a likely source of some of the stress in leveraged loans. It is a fragile cycle.

The average leveraged loan has dropped from a price of $97.53 in early May to $95.50 most recently, with $0.82 coming since the start of September alone (Exhibit 1). It is not the most severe drop in loan pricing even in the last year; prices from last October through January dropped by $4.81. Still, the most sensitive classes of CLOs have widened as loan prices have dropped and recently have moved sharply wider than levels of a year ago. The most liquid ‘BB’ CLO classes tracked by the Palmer Square index now trade at a spread of 750 bp over LIBOR, more than 35 bp wide of their mark in late December. The ‘BB’ debt of smaller and less liquid CLO managers recently has traded at spreads of more than 1,000 bp.

Exhibit 1: Loan prices and CLO spreads have weakened sharpened lately

Source: Palmer Square, S&P/LSTA via Bloomberg.

If weaker loan prices and wider CLO spreads reflected broad concerns about credit, then it is not showing up in other markets. ‘BB’ CLO spreads have widened this year while ‘BB’ high yield debt, which typically is less senior to loans with lower historic recoveries after default, have tightened (Exhibit 2). A similar pattern of wider CLO spreads and tighter corporate spreads shows up at other levels of high yield and investment grade corporate debt. It may be something unique about leveraged loan credit, but that seems doubtful.

Exhibit 2: Divergence this year between CLO and corporate credit

Source: Palmer Square, S&P/LSTA via Bloomberg.

The weakness in leverage loans and CLOs looks driven in large part by the CLO market itself. CLOs in 2019 have bought 72% of all leveraged loans, a record level, according to S&P. Retail investors continue to leave the leveraged loan market. At the same time, the share of leveraged loans rated ‘B+’ or lower has hit a record 65%. The combination of dominant CLO demand and rising ‘B+’ and lower credit has become a volatile combination. And the volatility is created by a pair of details of CLO structure itself: the impact of loan downgrades and the consequences of buying deeply discounted loans.

The downgrade of any CLO loan to ‘CCC’ counts against a limit on ‘CCC’ exposure, and if the deal exceeds that limit, bad things happen to the owner of deal equity. CLO managers often own the equity. In particular, deals often have a 7.5% exposure limit to ‘CCC’ loans. If the deal exceeds that limit by enough, then tests designed to protect senior classes force a diversion of principal and interest away from equity and toward paying down senior debt.

The rapid rise of ‘B+’ and weaker loans has left CLO managers with a thin cushion between a normally functioning deal and a troubled one. A downgrade of a single notch could easily push a deal over its ‘CCC’ limit. In fact, spreads on ‘B+’ and weaker loans have widened lately while spreads on ‘BB-‘ and stronger loans have tightened (Exhibit 3). Some ‘BB’ loans anecdotally have traded as tight as 175 bp over LIBOR, well inside the usual spread of 200 bp that defines a leveraged loan. The disparity between ‘BB’ and ‘B’ loans has all the fingerprints of a dominant CLO bid willing to pay a premium to buy protection against a sudden slide to ‘CCC.’

Exhibit 3: Disparity between ‘BB’ and ‘B’ spreads has the marks of CLO buyers

Source: S&P

The rising role of CLOs in leveraged loans also creates sudden breaks in the willingness of investors to buy loans at prices below $80. If a CLO buys a ‘B3’ or better loan above that price, the deal can use the full par amount of the loan in tests that measure the continuing strength of the deal. The deal can continue to use the full par amount of the loan even if the price later sinks below $80. However, if the CLO takes a new ‘B3’ loan on its books below $80, it can only use the market value of the loan to pass those tests. Buying deeply discounted loans not only immediately weakens the ability of the deal to pass its tests, it potentially weakens the deal further if the price continues to drop. Buying loans below $80 becomes a dangerous game for a CLO manager where a failed test leads again to diversion of principal and interest away from equity.

The implication for the leveraged loan market is that the rising role of CLO capital has created an air pocket below $80 where capital suddenly dries up and may not reemerge until prices drop well below the economic value of the loan. It potentially becomes a dangerous cycle where initial signs of any weakness in a ‘B’ credit triggers selling, and breaks in the concentration of capital at different price points allow the price to gap lower. The risk of sudden drops in ‘B’ loan prices add to their risk and widens their spread, and the cycle begins again.

Although demand from CLOs has helped broaden the market for leveraged loans since the 2008 financial crisis, the constraints of CLO structure have likely started to have an unexpected impact on the cost of credit in that market. ‘B’ credits now pay more, and it likely has more to do with the peculiarities of CLO structure than with the borrowers’ willingness and ability to pay.

* * *

The view in rates

The markets view of another Fed cut by the end of this year bounced up a bit from the week before, rising from 82% to 92%. Dialogue from the Fed remained vague as usual, so that offered limited guidance. The curve steepened, and 10-year implied inflation rise slightly. It is hard to be anything other than neutral on rates.

The view in spreads

Except for the leveraged loan and CLO markets, investment grade and high yield credit continue to tighten. Chalk that up to an accommodative Fed and perhaps to the Fed’s latest efforts to smooth liquidity in repo markets. MBS has lagged credit and should continue to trade at soft spreads largely due to heavy volumes of refinanced loans flowing through the market. MBS spreads should stay soft through the balance of the year and start to tighten thereafter.

The view in credit

Slowing global growth will almost certainly catch the most leveraged credits, and spreads in leverage loans reflect some of that concern. Leverage in investment grade corporate credit also has trended up this year. As for the US consumer, low unemployment, high income and high aggregate household wealth leave consumer balance sheets in good shape. The readiness of the Fed, the ECB and other central banks to backstop growth makes broad recession unlikely. The weakest credits should feel a slowing economy, but without recession, the averages should remain good.

john.killian@santander.us 1 (646) 776-7714

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