Signs of Danger in CLOs? Not So Fast

Author:
Laila Kollmorgen, CFA
CLO Tranche Portfolio Manager
Los Angeles

7 June 2019

A growing chorus is trumpeting the imminent demise of one of the longest running economic expansions the US has ever experienced. Some of the most vocal pundits are pointing to collateralized loan obligations (CLOs) as the next harbinger of doom, predicting that CLOs will follow the same path that collateralized debt obligations (CDOs) did as they helped bring on the 2008 financial crisis and resulting Great Recession.

The basic argument echoes what happened with the mortgage market in 2008: Corporate debt has risen, where a large share of the loans are to high-credit-risk companies. To top it off, a large share of those loans are “covenant-lite,” meaning short on lender protections. When the next recession hits, the story goes, these companies will not be able to manage their debts and bankruptcies will rise, with investors in CLOs bearing the brunt of the damage.

While economic cycles certainly share similarities, we think equating the CLO market of today to the CDO market of over 10 years ago is essentially trying to fit a square peg in a round hole. First, leveraged loans and CLOs are now subject to far stronger regulations, and they are exposed to intense scrutiny by sophisticated investors. Second, while the comparison between today’s leveraged loan market and 2008’s mortgage market seems easy to make, these two markets actually have little in common. And third, even when taking a very bearish view, CLOs are well covered if leveraged loan defaults were to rise significantly.

Here, we take a deep dive into the details the critics are missing.

Regulations are far stronger today, and loans and CLOs are highly scrutinized

Bank capital adequacy ratios have improved

The capital adequacy ratio (CAR) is an international standard aimed at promoting banking stability. The CAR measures a bank’s risk of insolvency from excessive losses. Currently, the minimum acceptable ratio is 8%.

Basel III in Europe, which became fully effective in January 2019, significantly increases the capital requirements for banks. US regulators similarly implemented changes to the banking system. Banks can increase their regulatory capital ratios by either increasing the levels of regulator capital (the numerator) or by decreasing the levels of risk-weighted assets (the denominator). Research has found that banks increase their capital ratios by reducing their risk-weighted assets and not by raising their levels of equity.1

One of the results of increased bank capital charges for below-investment-grade credits (whether they are bonds on a trading book or loans made to companies) is that banks hold less of them now. Currently, under Basel III guidelines, credits rated BB+ to B- are 100% risk-weighted, while those rated below B- are 150% risk-weighted. Before the global financial crisis (GFC), banks would syndicate the leveraged loans they made to companies and retain a portion of those loans. However, due to increased regulation and higher capital charges, banks no longer hold those portions and instead sell them through a syndication process. Syndication allows them to reduce their risk-weighted assets and keep their CARs high.

How does this affect the quality of the loans? On one hand, you could argue that prior to the GFC, banks had more “skin in the game” because they kept a portion of the corporate loan on their balance sheet. On the other hand, when banks syndicate the loan, it means that hundreds of independent institutional investors analyze each credit, seeking to verify the veracity of the financial information provided. These investors act as an independent set of eyes poring over the companies’ balance sheets. Through this process, it is the market who tells the banks if the underwriters and the rating agencies have done a good job.

Both sides of the argument are valid. Yet the lesson learned from the GFC was that the financial system needs to remain strong, and penalizing banks from holding below-investment- grade exposures furthers that goal, even if banks end up selling those exposures.

Lending standards are tougher

The bank bringing the leveraged loan credit to market must seek to comply with regulations known as the federal leveraged lending guidelines, introduced in 2013 and overseen by the Office of the Comptroller of the Currency (OCC), the Federal Reserve, and the Federal Deposit Insurance Corporation (FDIC). The guidelines recommend a maximum 6.0x debt-to-EBITDA ratio. Loans that exceed that standard require additional scrutiny from regulators. While these are guidelines, it is, ultimately, institutional investors who analyze each credit to determine whether they will invest or not.

Risk retention rules apply to European CLO managers

The idea behind risk retention is that CLO managers would be more diligent in the credit analysis process because they own part of the transaction, making them hold direct economic exposure to their investments.

In the US, risk retention for CLO managers was overturned in May 2018, when the courts determined that managers do not “originate” the leveraged loans. Rather, CLO managers purchase loans in the leveraged loan market from banks that originate the loans and, in turn, syndicate them to institutional investors.

However, in both Europe and the US, risk retention still applies to banks that originate and then securitize residential mortgages, commercial mortgages, and auto loans. Those banks must retain 5% of the transaction. CLOs are trickier. As mentioned above, the US regulator reversed the application of the regulation for CLOs. However, in Europe, CLO managers are still subject to the 5% risk retention requirement.

Despite regulators’ best intentions, implementation of risk retention in the US was negative for the leveraged loan market because CLO managers raised dedicated funds to purchase the equity tranche in deals issued. This resulted in a captive buyer for the equity who was willing to accept lower returns for a share in the management fee normally earned by the CLO manager. Perversely, the raising of capital to comply with US risk retention caused an increase in covenant-lite loans due to an overall increase in demand for leveraged loans.

With the repeal of US risk retention, the equity tranche – the riskiest piece of a CLO – now undergoes additional scrutiny through external, third-party investors. Ultimately, the more that independent institutional investors are involved in the purchase of leveraged loans, the more third-party questions are levied at the company, demanding information, covenants, and, ultimately, oversight.

Today’s leveraged loan market has little in common with 2008’s mortgage market

The US mortgage market was unregulated

One of the biggest problems that fed into the financial crisis was weakness in mortgage underwriting. Borrowers were able to self-verify income, and the lack of income verification meant that the assumptions about the borrowers’ creditworthiness and the value of the collateral in the home were wrong, leading to poor recoveries after default.

Additionally, the banks that were making the mortgage loans were themselves the arrangers and sellers of the securitizations, which were then bundled into asset-backed securitization (ABS) CDOs. This was a vertical business where the banks made money every step of the way.

In contrast, the US leveraged loan market is regulated by the OCC, the Fed, and the FDIC. The companies seeking to issue a loan have audited financial statements. Banks also work with private equity sponsors, who often are sector or company specialists and invest equity into the company that is issuing the leveraged loan.

Banks “gamed” rating agency methodologies, and the deals were not transparent

ABS CDOs and so-called “CDO-squared” transactions were a way for banks to recycle unsold lower-rated tranches from non-agency securitizations. In essence, securitizations of securitizations. Each securitization contained thousands of mortgages that were unable to be verified or analyzed.

In contrast, CLOs are backed by 150-300 different leveraged loans. Each loan has been independently sponsored by a private equity firm and/or arranged by a bank, rather than all loans being underwritten by the same bank, as was the case in ABS CDOs. In fact, each underlying credit in a CLO can be analyzed. And not only is underwriting diverse, but CLOs also have industry concentration limits as well as position limits. These limits increase the level of diversification in the CLO.

CLO structures have improved

Debt tranches in a CLO typically have 4% additional subordination through the issuance of single-B and larger equity tranches. Through the implementation of the Volcker Rule in 2013, CLOs no longer have exposure to high yield. (Exposure had been up to 40% before 2008 and between 5% and 10% after the crisis but before the Volcker rule.) Compared with similarly rated corporate debt, CLOs suffered much lower levels of default and losses between 1993 and 2017, with no CLO rated AAA or AA ever suffering a loss.

No AAA/AA Rated CLO Tranche Has Ever Suffered Losses

No AAA/AA Rated CLO Tranche Has Ever Suffered Losses

Source: Moody’s, as of 1 February 2019 for Corporate Default/Loss Rates 1983-2018 and Moody’s: Structured Finance: CLOs – Global Impairment and Loss Rates of US and European CLOs: 1993-2017, as of 25 June 2018. Any views are the opinion of the investment manager and are subject to change. For illustrative purposes only. We are not soliciting or recommending any action based on this material. Valid only as of the date indicated.

CLOs are not vulnerable to an uptick in corporate defaults

CLOs are well covered even in a bearish default scenario

While we anticipate the default rate for leveraged loans to remain below the historical average default rate of 3.1%, let’s consider a negative, multiyear, high-default scenario.

By many accounts, Morgan Stanley has one of the more bearish default views regarding the next US recession. Using Morgan Stanley projections for the next cycle of loan defaults, and assuming a 40% loss severity, we see cumulative losses of 10.7%. A loss that size has a very low likelihood of reaching any CLO tranches rated BB or higher because it is roughly the size of a CLO’s single-B and equity tranches.

A Bearish Default Scenario

A Bearish Default Scenario

Source: Morgan Stanley Research, Moody’s Investors Service, S&P LCD, FTSE Fixed Income LLC, as of November 2018

What’s more, this back-of-the envelope analysis doesn’t account for a CLO manager selecting better credits nor the fact that if default rates do reach that level, loan prices will be at significant discounts. This would allow the CLO manager to invest in deeply discounted securities, creating value in a CLO and improving the creditworthiness of the debt tranches. In fact, many CLO managers took the fourth-quarter 2018 sell-off in the underlying loan market to trade out of potential credit risk credits and into loans they do like – and, at the same time, add value by purchasing these loans at a discount to par.

The threat of “covenant-lite” loans is overblown

The share of covenant-lite US bank loans has been growing over the past several years and now accounts for nearly 80% of the leveraged loan market, according to S&P Global Market Intelligence.2 This trend has prompted concern among central bank regulators and the media, but the reality is more nuanced.

Recoveries in the leveraged loan market depend on enterprise value, often buoyed by hard assets. Covenant-lite loans allow companies to “kick the can” down the road, burning through liquidity that might have been used to repay the loan rather than forcing a borrower to negotiate with lenders at an earlier time. As a result, we do believe that recoveries will be lower than the historical level of 70% for leveraged loans. Various estimates have been discussed, but we agree that 60% is a likely recovery for covenant-lite loans. Within some sectors, such as technology, recoveries are likely to be lower.

With the repeal of US risk retention, we are finding that fewer covenant-lite loans are being issued, but recognize that this is a transition process and several risk retention funds or dedicated equity funds remain in existence.

The sky is not falling

We believe that CLOs should fare well in the next downturn given the improvements to the capital structure and the independent analysis of each credit in the leveraged loan market, despite lower recoveries from covenant-lite leveraged loans in a multiyear, high default scenario. There are significant differences between 2019 and 2008 – most importantly, in the form of increased regulation. While it may be easy to disparage CLOs because they are a securitization of leveraged loans (a CDO, in essence), they share little in common with the infamous ABS CDOs or CDO-squareds of 2008.

Yet those who follow history may feel that, with such an economic expansion, disaster is around the corner and it’s time for prudent investors to take their chips off the table and retreat to defensive asset classes. As prudent investors, we prefer to look at the data and take a holistic perspective rather than focus on specific details that may only resemble harbingers of doom.

Footnotes

Gropp, Reint and Mosk, Thomas C. and Ongena, Steven R. G. and Wix, Carlo, Bank Response to Higher Capital Requirements: Evidence from a Quasi-Natural Experiment (January 22, 2018). SAFE Working Paper No. 156. Available at SSRN: https://ssrn.com/abstract=2877771 or http://dx.doi.org/10.2139/ssrn.2877771.
Leveraged Loans: Another New Record for Covenant-Lite,” S&P Global Market Intelligence, 8 August 2018.

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