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Stress spreads in the market for complex investments called secured loan obligations, or CLO. This increases the risk of holding lower quality CLO stocks, which are among the few remaining opportunities for double-digit returns.
CLOs are vehicles that sell bonds and stocks to investors and then use that money to lend to (usually the riskiest) companies. Bonds and stocks are basically claims on the cash from these business loans. The highest rated CLO bonds are paid first, the second highest rated bonds are paid second, and so on down the rating scale. The equity of the CLO is paid last; the stocks pay a dividend with the remaining cash after all bond interest payments.
This can make CLO equity quite attractive when the economy is growing and most businesses can pay interest on these variable rate loans. In boom times, CLO stocks can earn 15% or more.
But this is not a boom time. And the US economy is not expected to grow anytime soon. More than 20 million people have filed for unemployment in the past five weeks, and Wall Street predicts the economy will contract at an annualized rate of 20% in the second quarter.
Thus, the quality of loans to companies that provide cash flow to CLO investors is “deteriorating rapidly,” according to a recent memo from Deutsche Bank.
Closed-end mutual funds that invest in bonds and CLO stocks reflect the concern of the market. CLO Equity Fund
(ticker: ECC) is down 56% year-to-date, and the CLO subordinated bond fund
Eagle Point Income Co.
(EIC) fell 48%. And funds focused on CLOs
(OXLC) and
XAI Variable Rate Alternative Income Term Trust
(XFLT) are down 35% and 43%, respectively.
Analysts say the deterioration in the lending market has been the worst in the market for “largely syndicated loans”, variable rate loans underwritten by banks and sold to groups of institutional investors, namely CLOs and managers. of funds.
CLOs have been the biggest buyers in the syndicated loan market for years. And during the decade of expansion following the financial crisis, demand for CLOs exploded as investors sought stable returns. As a result, many investors have been forced to accept extreme erosion of lender protections and high prices.
Today, syndicated loans are downgrading at an all-time high, which is likely to bode ill for CLO investors, especially investors in lower-rated CLO stocks and CLO debt.
Downgrades will become more problematic as a growing share of CLO loan ratings is cut at the three lowest levels before the default (CCC +, CCC and CCC-). When the share of CCC-rated debt in a CLO’s portfolio exceeds a certain threshold, generally 7.5%, its manager is forced to devalue the value of this very low-rated debt.
CLO’s median portfolio has already broken that 7.5% threshold, according to Wells Fargo, doubling to 8.1% from 4.05% in just one month. And S&P Ratings found that the average CLO of syndicated loans it rates holds almost 12% of its portfolio in CCCs.
This is all important, because when the values of CCC-rated business loans are reduced, it reduces the additional loan value cushion that CLOs are required to hold to hedge against losses. If this cushion is reduced enough, it leads to lower ratings and diverts interest and dividend payments from lower-rated stocks and bonds from a CLO.
Notably, loan downgrades and signs of stress did not completely freeze the market. So far this year, managers have issued $ 20 billion in new CLOs, down about 50% from last year, according to LCD, a division of S&P Global Market Intelligence.
But what matters most is the severity of any coronavirus fallout that hits the business loan market. This was demonstrated by a stress test recently published by S&P Ratings.
S&P found that if 10% of loans in CLO portfolios defaulted and 20% were downgraded to CCC, losses and downgrades would be manageable: while 70% of BBB-rated CLO bonds would be downgraded to junk, bonds better. rated bonds would fare much better, with 65% of A-rated bonds retaining their investment grade status and 92% of top-rated CLO bonds retaining their AAA rating.
If those numbers double, with 20% of loans in default and 40% of them downgraded to CCC, things start to get much worse: almost 80% of A-rated bonds would be downgraded to junk and 90% of AAAs would be downgraded. , so just a step up.
In other words, there is a possibility that the coronavirus pandemic could cause losses for even higher-rated CLO bond investors, who did not earn double-digit returns to offset them for their risk.
And the fact that this is being discussed means that future investors in CLO stocks should be extremely careful.
Write to Alexandra Scaggs at [email protected]
