The Coming CLO Meltdown

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Prices in key parts of the almost $700 billion market — which finances companies with less-than-stellar credit scores — have remained deeply depressed, typically under 70 cents on the dollar, even as other financial markets have rallied. Back in February, before the Covid-19 pandemic throttled the economy, these lower-rated CLO slices hovered near par.

That’s partly because the securities have been largely left out of stimulus programs. But it’s also because the risky corporate loans that were stuffed into the CLOs are being downgraded so frenetically that investor safeguards in the securities may get overwhelmed.

If that happens, the firms that manage the CLOs will be forced to dump under-performing loans at fire-sale prices or suspend the cash payments they make to investors.

Some analysts expect up to a third of CLOs to soon have to limit payouts to holders of the riskiest and highest-returning part of the CLO structure — the equity portion. The pain could quickly spread to less risky tranches, too.

The exact extent of the damage will become clearer in the coming weeks as managers submit monthly and quarterly updates of their assets, which will determine whether they’ve breached key thresholds on quality and solvency.

These risks prompted Moody’s Investors Service to warn last week that it may cut the ratings on 859 CLO securities, accounting for nearly a fifth of all such bonds it grades.

CLO Update: 10% May Stop Paying Because of Collateral Markdowns

(Bloomberg) — More than 10% of U.S. collateralized loan obligations are now at risk of cutting off cash payments to holders of their riskiest portions amid a surge in downgrades among leveraged loans backing the securities, according to analysts at Nomura Holdings Inc. and Wells Fargo & Co.

About 13% of portfolios failed their so-called junior overcollateralization tests in April, based on a Nomura analysis of roughly 750 CLO deals where payment data was available. Wells Fargo said in a note Thursday that 11% of those it analyzed didn’t pass, and more than half are exceeding standard caps that limit CCC rated loans they can hold to 7.5% of the portfolio, while about 14% breached Caa limits.

CLOs have a battery of monthly compliance tests used to determine payouts to investors of varying levels of priority. But as downgrades to leveraged loans continue to pile up amid the coronavirus pandemic, many managers are now overburdened with more low-rated debt than typically allowed. That’s forcing them to either dump poor performing loans at fire-sale prices, or potentially cut interest payments to investors.

“Rating agencies are being much more aggressive in downgrading loans to CCC versus during the financial crisis, and that could result in higher levels of OC breaches,” said Steven Oh, global head of credit and fixed income at PineBridge Investments. “Some of the OC failures are likely to extend even higher up the capital structure.”

While most of the OC test failures were for the riskiest equity portion and lower-rated debt tranches, there have already been a handful of breaches at the AA level, and at least one at the AAA level.


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