The current macro environment has seen a bit of flight to safety and increasing credit spreads. So, I’ve been looking at the leveraged loan & CLO markets and how they have been handling the transition to SOFR from LIBOR. The spread between eurodollar and 3 month SOFR has become significant enough that I’m wondering how well CLO managers are able to account for default risks as margin pressures increase and cash flows drop.
Over the last 2 years we’ve had record issuance of CLOs, mostly on LIBOR terms. New issuance is now all in SOFR. New leveraged loans issued in SOFR terms may have insufficient credit spreads built in, as SOFR itself has no credit component, unlike LIBOR, and previously significant CLO demand suppressed spreads. Additionally, derivatives that could be used for hedging SOFR are still in their infancy and may themselves insufficiently compensate for underappreciated credit risks.
Looking at S&P’s info on CLO constituent ratings here. They model stress with very conservative parameters (150bps and -5% EBITDA margin). Even under these conservative parameters there’s still this:
“Based on the stress, reported EBITDA cash interest coverage ratio remains relatively resilient across the portfolio. Free cash flow deficits are a more significant concern, rising to about 23% of the portfolio from 14%, under our stress case. As expected, issuers rated ‘B-‘ and lower are most vulnerable to cash flow deficits. In this scenario, good liquidity positions and the absence of near-term refinancing needs will likely provide a buffer to downgrades. However, rating outlook revisions or downgrades will become increasingly likely if cash flow deficits persist. Increased cash flow deficits for ‘CCC’ category issuers, which account for over 9% of our speculative-grade portfolio, is more concerning because these issuers often have unsustainable capital structures.”
I’ll leave it to smarter people than me to guide this discussion, but I’m expecting a series of ratings downgrades over the next few months, but far too late for investors in CLOs to be made aware of the increasing default risks of constituent loans.
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