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CLOs made it through the financial crisis relatively unscathed
Rapid pace of loan downgrades may mean this time is different
As U.S. financial markets have rebounded feverishly this past month from the worst of the coronavirus-induced sell-off, one asset has been conspicuously absent from the rally: the collateralized loan obligation.
Prices in key parts of the almost $700 billion market — which through large doses of Wall Street alchemy provides financing to companies with less-than-stellar credit scores — have remained deeply depressed, typically fetching less than 70 cents on the dollar. Back in February, before the Covid-19 pandemic throttled the economy, they hovered near par.
Part of the reason for this is the simple fact that CLOs, as the securities are known, have been largely left out of the stimulus programs hastily crafted by U.S. officials to shore up markets. But there’s a bigger and more ominous force at work that has investors bracing for the kind of pain they’ve never experienced in the decades that the market has existed.
Credit ratings on risky corporate loans that were stuffed into the CLOs are being downgraded at a pace so frenetic that it threatens to overwhelm safeguards that were put in place to ensure the securities’ financial strength. And if that happens, the firms that manage the CLOs will be forced to dump under-performing debt at fire-sale prices or suspend the cash payments they hand over to their investors.