I think there’s a solid chance that many collateralized loan obligations (CLOs) will default in the coming months. If you don’t know what CLOs are, here’s a good article describing them and why they’re a problem; but essentially they’re a pool of corporate loans, usually of low quality – think Hertz who, by the way, issued $900m worth of bonds last fall – that are collateralized together and sold to investors. It effectively functions like debt vs. equity on a balance sheet, in that purchasers of the lowest equity tranche earn the highest interest payments, but they’re also the first owners impacted by losses; conversely, purchasers of the highest “AAA” tranches earn the lowest returns, but they only incur losses after all other tranches have been (effectively) wiped out.
I (and others on FinTwit) are speculating that there’s going to be a massive default of CLOs over the summer. The reasons for this being:
1- Many CLOs have already been either placed on a watchlist (to be downgraded) or have already been downgraded. Per the Bloomberg article above, “since early March, some 440 of the more than 1,500 obligors held in broadly syndicated U.S. CLOs rated by S&P have either been downgraded, placed on a negative CreditWatch, or both. Consequently, S&P has gradually put lower-rated CLO tranches themselves on negative CreditWatch, with the tally reaching 418 as of May 8. That usually either results in a downgrade or no change within 90 days. Meanwhile, Moody’s Investors Service has 859 CLO tranches worth $22 billion on downgrade watch.”
The holders of these CLOs, many of whom are banks, insurance agencies, and asset managers have stringent requirements to unload these CLOs if they are downgraded below a certain threshold; ECC, for example, is required to dump CLOs once the number of CCC rated securities exceed 7.5% of the portfolio.
2- There has been a rampant increase in “covenant-lite” loans in recent years, many of which are collateralized within CLOs. This, coupled with the fact that rating agencies are deliberately over-rating debt, provides the perfect opportunity for loads of defaults to occur simultaneously should, for example, the economy shut down for two months and loads of borrowers miss their payment obligations. Also ‘zombie companies‘.
Now, why July? Well, frankly most of the loans that are collateralized within CLOs are required to make quarterly payments. For the most part, these CLOs were able to cover their payments for Q1 – but remember, shutdowns weren’t really wide-spread until the very end of March. Most of the impact of the shutdowns will be reflected in Q2 results. Q2 ends on June 30, after which, payments will be due.