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Loan values plunge, leveraged borrowers reach for cash

admin | March 20, 2020

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. This material does not constitute research.

The leveraged loan market continues to plunge as large parts of the US economy shut down to contain the coronavirus. An expected sharp drop in revenues has triggered a surge in draws on revolving lines of credit by leveraged companies, improving chances of survival but reducing potential recovery rates. And as loan prices plunge, many CLOs now show portfolio values too low to cover even their ‘BBB’ classes. But ‘AAA’ classes still look like fundamentally sound cash flows at wide spreads.

Loan prices go into a tailspin

The risk of downgrade and default has sent loan prices into a tailspin. The price of the average loan in the S&P/LSTA Leveraged Loan Index since the start of March has dropped from $95.18 to $78.40, nearly an 18% drop (Exhibit 1). But the average loan in the more liquid S&P/LSTA 100 Index has dropped from $95.90 to $77.06, a 20% drop. The sharper drop in more liquid assets signals a sudden and strong investor preference for cash.

Exhibit 1: Loan prices have quickly dropped below the 2014-2016 energy crisis

Source: Bloomberg, Amherst Pierpont Securities

The quick plunge in average loan prices below $80 raises the potential for even sharper drops in price. CLOs buying loans below $80 usually have to carry the loans at purchase price instead of par for the purpose of CLOs’ par overcollateralization tests. Deals that fail those tests could see cash diverted from equity and lower classes to more senior classes. With CLOs still the largest marginal buyer of loans, an air pocket in demand for loans below $80 likely makes these loans more volatile.

Overall loan pricing likely reflects investor expectations of months of sharply lower borrower revenues with a range of issuers having limited room to maneuver. Corporations with more than $50 million in earnings taking out leveraged loans in 2018 and 2019 had an average ratio of EBITDA-to-cash-interest of around 3.5x. A sudden and sharp drop in earnings would threaten the ability of many borrowers to cover debt payments.

Borrowers reach for their lines of credit

Borrowers themselves show signs of preparing for a cash shortfall. Issuers of leverage loans have publicly disclosed in March nearly $54 billion in draws on lines of credit, with more than three-fourths drawn since March 16 (Exhibit 2).

Exhibit 2: Leveraged companies have started tapping lines of credit

Note: new draws on lines of credit by SEC-registered borrowers in the leverage loan market. Source: S&P Global Intelligence, Amherst Pierpont Securities

Drawing on a line of credit can have mixed results for the CLOs that invest in the borrower’s institutional term loan. Even though most term loans in recent years have come with limited covenants, the associated revolving lines commonly come with traditional covenants controlled by the originating banks. Drawing down a line brings these covenants into play, allowing the banks to discipline the borrower’s finances while putting cash on the balance sheet. But revolving lines often are senior to the institutional term loan. So while a drawn line improves the chances for the borrower to weather a cash crunch, it lowers potential recovery for the institutional loan investors if the company fails.

Market value coverage for median ‘BBB’ and lower classes falls short

The plunge in loan prices has left the market value of many CLO portfolios well below levels needed to repay all debt if the portfolio were liquidated immediately. Market value overcollateralization below 100% indicates a shortfall in ability to pay a class of debt and all classes senior to it. The median MVOC of outstanding ‘BBB’ classes started March near 110% and has dropped to 98% (Exhibit 3). The median ‘BB’ has dropped from 104% to 93%. And the median ‘B’ has dropped from 101.5% to 90.8%.

Exhibit 3: Median MVOC for ‘BBB’ classes and below has dropped below 100%

Source: Bloomberg, Amherst Pierpont Securities

The median MVOC for ‘A’ and higher rated classes has also dropped in March but remains above 100%.

Lower MVOCs across CLO classes and heavy demand for liquidity has widened CLO spreads sharply. Spreads on ‘BB’ and ‘BBB’ classes still remain below levels seen in the 2014-2016 energy crunch (Exhibit 4). But spreads on ‘A’ and higher classes have widened beyond the levels of the 2014-2016 energy crunch. As in the loan market, this signals sharpening investor preference for cash. CLO portfolios seem to be selling their most liquid investment grade holdings first.

Exhibit 4: IG has widened proportionately more than HY CLOs, a liquidity signal

Source: Bloomberg, Palmer Square, Amherst Pierpont Securities

Sound cash flows at wide spreads

‘AAA’ CLO classes still represent fundamentally sound cash flows at wide spreads. The NAIC’s recent stress test of CLOs (reviewed here) using elevated defaults and low recoveries suggested ‘A’ and higher rated classes would not take losses in the tested scenarios. The protection comes partly from loan recoveries but more from diversion of deal cash flow to senior classes as deal credit quality erodes. Credit quality does look likely to erode, but CLO structure should ensure that ‘AAA’ classes still get all cash flows due. The relatively sharper widening in investment grade CLO debt suggests demand for liquidity is disproportionately driving spreads wider in those classes. Investors with cash and a longer investment horizon have a good opportunity in the most highly rated CLO debt.

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