By the Numbers

Use price not WARF to track CLO loan risk

| September 16, 2022

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.

In a market with lots of volatility, CLO investors may find managers’ exposure to loans priced at $80 or below a better credit risk indicator than the weighted average rating factor, or WARF.  Investors have long used WARF to assess risk in a pool of loans. But reported WARF is likely to be stale in a fast-moving market and a weak indicator of both loan risk and CLO manager performance.

The share of loans price at $80 or below in the Morningstar/LSTA loan index rose to 3.3% at the end of August.  While the level is much lower than recent pandemic highs, it has moved up every month in 2022 and has tripled from a year ago (Exhibit 1).  The share of credits in the index rated ‘CCC+’ or below, however, has been stable this year, hovering around mid-5%. The weighted average loan rating also has edged up this year, but only from 9.22 at the start of January to 9.29 at the end of August.

Exhibit 1: Loan prices move much faster than loan ratings

The CCC+ or below rating categories include credits rated CCC+, CCC, CCC-, CC, C, and D by S&P.  Both shares of CCC+ or below credits and $80 or below loans in the Morningstar LSTA loan index are calculated based on the par amount outstanding.
Source: LCD, Amherst Pierpont

While rating agencies regularly review the performance of rated underlying loans, the frequency often corresponds to companies’ quarterly earnings.  In a relatively calm market with low perceived credit risk, the share of low-priced loans and distressed credits in the index is stable or even declining.  In March 2020, rating agencies did reach out proactively to issuers of loans for indications of financial stress, leading to a wave of downgrades in the following months. But loan prices are more responsive than credit ratings in a volatile market and often move ahead of rating agencies’ review schedule, making the rating-based WARF a less helpful risk indicator to investors.

Many managers have larger exposure to $80 or below loans than the index

The median share of loans priced $80 or below in active CLO loan portfolios stood at 3.62% in August, slightly higher than the 3.3% in the Morningstar/LSTA loan index.  The median share of ‘CCC+’ loans in active CLO portfolio stood at 4.40%, well below the index mark of 5.36%. A CLO with lower exposure to distressed credits or a lower WARF may be perceived as taking less risk than the broad market. But the share of loans priced $80 or below may paint a different picture.

Managers’ low-priced loan exposure has weighed on performance

Managers who trailed the loan index performance in the summer, after adjusting for risk, mostly have greater exposure to loans priced at $80 or below (Exhibit 2).  For the June, July and August performance periods, 44 managers tracked by Amherst Pierpont delivered negative excess returns. Of those managers, 35 had and above-index exposure to loans priced $80 or below. Their exposure ranged from 3.48% to 10.51%.

Exhibit 2: More exposure to low-priced loans, lower excess return

The red dot represents the loan index exposure to $80 or below loans at 3.3% as of August 2022.  The green dots represent 37 managers whose exposure to the $80 or below loans was lower than the index.  The orange dots represent 16 managers whose exposure to the $80 or below loans and CCC+ or below credits were both higher than the index.  The blue dots represent the remaining 30 managers who had higher $80 or below loans but lower CCC+ or below credit exposure than the index.   Data as of August 2022.
Source: LCD, INTEX, Amherst Pierpont

WARF has a weak relationship with managers’ performance

Managers’ average WARF in August ranged from 2573 to 3171 with a median of 2814.  But WARF has a much weaker correlation with the managers’ excess returns (Exhibit 3).  For example, MJX-managed CLOs had an average WARF of 2602, but MJX trailed the index by 69 bp for the three monthly reporting periods through August.  In contrast, Elmwood-managed CLOs had an average WARF of 2639, but Elmwood outperformed the index by 40 bp in the same period. While the average WARF from the two managers’ loan portfolios is comparable, MJX’s exposure to loans priced at $80 or below stood at 8.22%, significantly higher than the 1.27% in Elmwood portfolios.

Exhibit 3: Managers’ performance has a loose relationship with the WARF

The green dots represent 37 managers whose exposure to the $80 or below loans was lower than the index.  The orange dots represent 16 managers whose exposure to the $80 or below loans and CCC+ or below credits were both higher than the index.  The blue dots represent the remaining 30 managers who had higher $80 or below loans but lower CCC+ or below credit exposure than the index.   Data as of August 2022.  Numbers in parentheses reflect the manager’s exposure to $80 or below loans.
Source: INTEX, Amherst Pierpont

Looking back, the share of low-price loans and distressed credits has moved in tandem with rising defaults and downgrades.  WARF is still a useful credit metric for gauging risk in loan portfolios, but managers’ exposure to loans priced at $80 or below looks like a better risk indicator in a volatile, fast-moving market.

Caroline Chen
caroline.chen@santander.us
1 (646) 776-7809

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