The Big Idea

A bigger role for CLOs

| June 4, 2021

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 market has steadily opened up this year for leveraged borrowers, including the ones funded by leveraged loans and CLOs. Gross and net issuance is up. Spreads are tighter. Markets in high yield and private debt are seeing the same. Some of that is almost certainly due to persistent low rates and the need for yield. But in the case of CLOs, some is also due to seeing the sector last year largely pass its second major stress test in as many decades. The ability of CLO structure to weather last year’s storm opens the door to a bigger role in leveraged finance.

Probably the most important metric for the CLO market through pandemic has been the share of loans rated ‘CCC’ or below. That metric can trigger important protections for senior debt typically when it exceeds 7.5% of the loan portfolio par balance. A deal will haircut the portfolio par balance based on the price of ‘CCC’ loans above the 7.5% threshold. Along with haircuts to par based on defaulted loans and on any loans purchased at a deep discount to par, excess ‘CCC’ exposure can trigger diversion of cash flows to senior classes to begin paying down their principal balance. This mechanism is at least as important if not more important that other protections for CLO senior debt such as credit tranching, loan concentration limits, portfolio quality tests or interest diversion or interest coverage tests. Just as credit starts to deteriorate in CLO collateral, the tests sensitive to ‘CCC’ balances shorten the weighted average life of senior debt and trim credit exposure.

CLO ‘CCC’ exposure started in January 2020 at 4.11% of the sector’s par loan balance, peaked in May 2020 at 12.31% and has dropped steadily to finish last month at 7.24%. ‘CCC’ exposure is still higher than pre-pandemic levels, but it has improved substantially from peak exposure.

The overcollateralization tests triggered last year in part by rising ‘CCC’ exposure worked. The percentage of outstanding deals failing any OC test started January 2020 at 2.1%, peaked in June at 17.3% and stood through last month at 2.8% (Exhibit 1). Diverted cash flow protected senior debt.

Exhibit 1: The share of CLOs failing OC tests spiked last year but has dropped

Note: share calculated based on number of CLOs, not par balance. A failed OC test occurs when any combination of ‘CCC’ exposure, defaulted loans or discount obligations cause portfolio par balance to drop below specified overcollateralization thresholds. Thresholds vary by CLO debt rating.
Source: Intex, Amherst Pierpont Securities

Although it is too early to close the book on CLO performance through pandemic, the CLO 2.0 market so far continues to escape default on debt. S&P since 2010 has rated 9,224 classes of CLO 2.0 debt with no defaults so far (Exhibit 2). Of course, seven classes now stand at ‘CCC’ or below, most issued between 2012 and 2014. Nevertheless, on the ‘AAA’ and ‘AA’ classes that typically make up more than 70% of a typical CLO’s debt, the risk of default looks remote

Exhibit 2: A track record of limited defaults in CLO 1.0 and none so far in 2.0

Source: S&P as of 4Q2020, Amherst Pierpont Securities

Another notable aspect of CLO performance through 2020 is that the structures did not become forced sellers. In fact, more than $93 billion in new CLOs came to market last year while leveraged loan funds saw nearly $28 billion in net outflows. Term debt, not subject to mark-to-market margin calls or other similar mechanisms, made CLOs strong hands in leveraged finance.

This is not to paint an unblemished picture of CLOs. The sector, like most parts of the private credit markets, shows trends investors need to monitor. The share of CLO portfolio loans rated ‘B-‘ stood in January 2020 at 19.97% but has jumped most recently to 24.90%. The share of loans from issuers with ratings on Outlook Negative has jumped. The par balance of outstanding CLOs has dropped. The cushion protecting the average CLO from failing its junior overcollateralization test—and diverting cash flow to senior classes—has narrowed.

The broader point is that CLOs, which currently buy the majority of leveraged loans, have weathered a second major stress test well. It was clearly a shorter period of stress than the aftermath of 2008, and Fed and fiscal intervention—especially the Fed purchases of corporate debt—may have particularly helped all parts of leveraged finance. But nevertheless, the structure protected senior debt and became a net buyer of assets. That should make investors and possibly regulators more confident in the structure and its ability to bring stable capital to leveraged lending over the long run.

For investors, good prospects for continued CLO growth extend the timeline and expand the opportunity for earning returns from expertise in the asset class. A broader audience of investors, possibly encouraged by the market’s recent track record, helps with liquidity, too. The prospects for a bigger and more liquid CLO market continue to improve.

* * *

The view in rates

Excess liquidity continues to shape the entire rates market. Overnight Treasury repo and SOFR sit around 1 bp. Recent settings on 3-month LIBOR have dipped to a record 12.85 bp. Fed reverse repo agreements, offering a 0% rate, stood June 4 at $483 billion.

Concerns about a persistent oversupply of cash also have shaped the longer end of the curve. The 10-year note has finished the most recent session at 1.55%, despite 10-year breakeven inflation at 2.43%. The negative 10-year real rate implies heavy supply of 10-year cash against limited demand to borrow.

The Treasury yield curve has finished its most recent session with 2s10s at 141 bp, flatter from a few weeks ago. The 5s30s curve has finished at 145 bp, also flatter from a few weeks ago.

The view in spreads

The conversation about Fed tapering continues. MBS have widened in the last few weeks but should stay relatively tight—and the dollar roll in MBS special—as long as Fed and bank net buying continues to soak up almost all net MBS supply. The nominal spread between par 30-year MBS and the interpolated 7.5-year Treasury yield closed recently at 67 bp, just 8 bp off the tightest level in MBS market history. Refi risk may also be creeping back into MBS. Primary 30-year mortgage rates have dropped below 3.0% in several surveys, and data from the Bureau of Labor Statistics show employment in the mortgage industry up 30% from three years ago, giving originators plenty of capacity to chase loans.

In credit, low rates should continue supporting corporate balance sheet strength. Ratios of EBITDA to interest expense are in the middle of the range despite high ratios of debt to EBITDA. Investor demand for yield should keep spreads relatively tight.

The view in credit

By the end of 2021, US GDP could be above levels projected before Covid for late 2021. That would represent one of the fastest and strongest rebounds from recession in US history. Consumers should continue to build strength. Aggregate savings are up, home values are up and investment portfolios are up. Consumers have not added much debt. Corporate balance sheets have taken on more leverage, although mitigated by strong cash balances and low interest costs. EBITDA-to-interest-expense is at healthy levels. Strong economic growth in 2021 and 2022 should lift most EBITDA and continue easing credit concerns. Eventually, rising interest expense should compete with EBITDA growth. But not for a long time.

Steven Abrahams
steven.abrahams@santander.us
1 (646) 776-7864

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