(Bloomberg) — Wall Street’s engineering was supposed to turn loans to junk-rated companies into relatively safe bonds known as collateralized loan obligations. As the new coronavirus slams the economy, some investors are finding that safety to be fleeting.
Interest and principal payments are at risk of being cut off for investment-grade CLOs in around a dozen different transactions totaling a few billion dollars, according to people with knowledge of the matter. The notes at risk have ratings as high as the A tier, well within high-grade territory, and were sold by name-brand money managers like Marathon Asset Management and Pretium Partners, the people said.
The securities are being battered as the Covid-19 pandemic is bringing an economic downturn far worse than many CLOs were designed to withstand, with some estimates for unemployment in the second quarter reaching 30%. Loans are getting downgraded and their value is dropping, which is triggering protections designed to protect the safest securities issued by CLOs, those rated AAA.
It’s the first time these safeguards, known as senior overcollateralization tests, have been this widely triggered since the 2008 financial crisis. Many more deals could meet the same fate in the coming months. CLOs, a $700 billion market of securities carrying ratings ranging from junk to AAA, were largely left out of Federal Reserve stimulus programs.
“I don’t know anybody that modeled a CLO, or any other structured product, around unemployment soaring from about 3% to the levels we could be facing in the next few weeks,” said Elen Callahan, head of research at the Structured Finance Association, a trade group. “If you told an analyst to model that, they wouldn’t know what to do.”
The lowest-ranking securities sold by CLOs are most at risk. Of the roughly 900 deals that have posted data over the last month, around 21% have had cash payments cut down or cut off from the riskiest portion of their deals, known as the equity, according to Bank of America. In certain cases, junk- rated notes, which are less risky than the equity, have been affected as well. In mid-April, some analysts were expecting as many as 1 in 3 CLOs to have to limit payouts to holders of their riskiest securities.
Prices can end up dropping on securities in a deal where payments have been cut off, because investors worry about the quality of the loans backing the transaction, said Jason Merrill, a CLO specialist at Penn Mutual Asset Management. “It’s broadly considered a sign of deal distress,” Merrill said.
While investors might expect high-yield securities to suffer in a downturn, investment-grade instruments are supposed to be less vulnerable. During the last financial crisis, CLO bonds rated AA or AAA saw no defaults due to downgrades of the underlying loans. The default rates for A and BBB rated notes were infinitesimal, amounting to less than 0.01%, according to the Structured Finance Association’s Callahan.
Striking for me is the similarity to the subprime crisis last decade, particularly the paragraph that reads ” Wall Street’s engineering was supposed to turn loans to junk-rated companies into relatively safe bonds known as collateralized loan obligations. As the new coronavirus slams the economy, some investors are finding that safety to be fleeting. ”
Same thing as last time, a bunch of PHDs convinced the ratings agencies that their models were right, investors bought bonds on the assumption that investment grade ratings meant anything, and now after the banks and the managers get paid their fees and are in their mansions in the Hamptons…the investors lose their money. Again.