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Wider loan spreads challenge CLO managers

| December 6, 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.

With spreads between the strongest and weakest leveraged loans at their widest levels in decades, CLO managers should have plenty of opportunity to show their value. ‘B’ loans continue to come to market, and CLO managers continue to have trouble absorbing them.

Spread between higher- and lower- rated leveraged loans reach historic wides

The gap between spreads of higher- and lower-rated loans continues to widen.  The spread in November for ‘BB/BB-’ borrowers tightened to L+188, a post-crisis low (Exhibit 1). Meanwhile, the spread for ‘B- ’ borrowers widened to L+498, the second-widest level in three years. The average spread of ‘B’ or ‘B+’ borrowers remain elevated, over L+390 since July.

Exhibit 1: New-issue TLB spread widens between ‘B-’ issuers and higher-rated issuers

Source: LCD, S&P Global Market Intelligence

The gap between ‘BB/BB-’ borrowers and ‘B’ borrowers has consequently tripled from 99 bp in January this year to 306 bp last month, the highest reading in at least 10 years (Exhibit 2). The majority of this gap is the spread between ‘BB/BB-’ and ‘B/B+’ borrowers, which reached its widest level of 233 bp in at least 20 years.

Exhibit 2: Majority of spread between BB/BB- loans and B- loans is spread between BB/BB- loans and B/B+ loans

Source: LCD, S&P Global Market Intelligence

Wider spreads in ‘B’ loans worsen their surplus and challenge CLOs’ marketability

Wider spreads raise the risk of downgrade for the weakest leveraged loans. These borrowers are the most vulnerable in a slowing economy. The wider spreads on ‘B’ loans will likely challenge those borrowers if they have to issue or rollover debt at high spreads. Rating agencies may lower their ratings on these issuers, too. Currently, ‘B’ loans constitute a record 65% of the $1.25 trillion syndicated loan market, so the number of ‘B’ loans downgraded could reach record highs, even at a similar rate of downgrade as during past episodes of economic softening.

CLOs, a major player in the leveraged loan market, have bought around 72% of new loan issuance to date, but they seem less inclined to keep buying ‘B’ credits for several reasons. First, CLO classes ‘BB’ and lower are most sensitive to falling loan prices because of their minimal credit support. The widening spreads of ‘B-’ loans will likely cause the spreads on those junior CLO classes to widen, too. Second, the potential downgrades of these leveraged loans from ‘B’ to ‘CCC’ could eventually trigger the CLOs to defer interest payments on their junior classes. As investors grow more wary about plummeting loan prices, they penalize managers who hold too many loans with significant price drops. The surplus of ‘B’ loans combined with their perceived risk make it increasingly difficult for CLOs to absorb ‘B’ loans.

CLO investors are becoming sensitive to ‘B’ loan exposure as volatility in loan markets is expected to continue at least through the first half of 2020. The recent Marathon CLO 14 deal has documentation that limits the amount of leveraged loans ‘B3’ and lower to 25%.  Accelerated downgrades in ‘B’ loans should keep pressure on CLO spreads and inspire other deal provisions. And CLO managers should have plenty of opportunity to prove their value.

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