The biggest buyers of US junk loans are expected to shrink their exposure to the $1.4tn market in 2023, as the Federal Reserve’s campaign of interest rate rises sparks rating downgrades and defaults.
Collateralised loan obligation vehicles own roughly two-thirds of America’s low-grade corporate loans — but may be forced to reduce their exposure because of credit downgrades, which could unsettle the markets and make it harder for companies to obtain financing.
CLOs, which package up such loans into various risk categories before selling the slices on to investors, have performed well during tough economic times, but analysts say mechanisms designed to protect investors holding higher-quality tranches could reduce the vehicles’ appetite for loans to risky, highly-indebted borrowers.
US CLO issuance ballooned during the depths of the pandemic, reaching an unprecedented $183bn in 2021 as near-zero borrowing costs sparked a broader explosion of capital market activity. Even as the Fed tightened monetary policy last year to tackle inflation and other parts of the global fixed-income market stuttered, CLOs raised a further $126bn — the third-largest annual figure on record, according to data from Refinitiv.
But CLOs have caps on how much very low-grade debt they can hold, with a typical threshold of 7.5 per cent for so-called “CCC” buckets containing highly risky loans carrying ratings near the bottom of the quality spectrum.
Against a backdrop of higher borrowing costs sparked by Fed rate rises and fears of recession, analysts are warning that those limits will be breached. When these protective switches are tripped, cash flows to investors holding the riskiest CLO tranches, known as “equity”, can sometimes be cut off, redirecting payments to investors higher up the pecking order.
Such a situation could also potentially curb demand for fresh leveraged lending just as many riskier borrowers start to think about how to refinance themselves after a burst of debt issuance during the cheap money days of the Covid crisis.
“Leveraged loans, the underlying collateral in CLOs, are expected to face increased stress, as interest costs are rising and earnings are likely to drop simultaneously,” analysts at Barclays wrote in December. “In our view, issuers will likely face cash flow pressure, eventually resulting in rising downgrades and defaults.”
For some CLOs, that would mean an uncomfortable overflow of CCC buckets and a desire to reduce exposure to corporate borrowers at risk of downgrade.
“We’re not talking about breaching the 7.5 per cent threshold by just a little bit,” said Steve Caprio, head of European and US credit strategy at Deutsche Bank Research. “We’re talking about CCCs potentially going as high as 12 to 15 per cent in the worst-case scenario.”
Analysts at Bank of America expect CCC buckets to increase to “8-10 per cent in a stress and potentially even 15 per cent in a severe stress scenario”, noting that the peak Covid CCC concentration in CLOs was 10 per cent.
Swiss bank UBS also believes “a surge in leveraged loan credit deterioration should increase CCC holdings in CLOs to [about] 15 per cent, drying up demand from CLOs”.
Caprio added that it would be “difficult to entice a new investor” to wade into the lowlier-rated CLO tranches when the risk of having regular payments turned off is “actually quite elevated”.
CLOs’ risk exposure varies, and many managers have built up protection against overflowing low-grade debt buckets. The share of CCC-rated loans in CLO portfolios has fallen to around 4 per cent, Barclays said. “Thanks to CLO managers’ active trading, defaulted assets in CLO portfolio has always been lower than the broader leveraged loan default rate.”
“There’s a lot of cushion before it really is a problematic dynamic for CLOs,” said Jeff Stroll, chief investment officer at Post Advisory Group.
Stroll added that to reach a situation where cash flows are diverted from the riskiest CLO tranches there would need to be “a lot of downgrades”. “In our deals, we’d probably have to see close to 20 per cent CCC baskets.”
Still, “there has been this kind of sentiment shift you can feel towards proactively trying to manage this as best as possible”, he said.
Concerns about overflows of low-quality loans in CLOs were “probably more valid for pre-Covid and especially vintages from the 2016 commodity crisis”, said Rishad Ahluwalia at JPMorgan. “The CCC ratios in the last two to three years of CLOs are a lot lower than the average.”
Ahluwalia said CLOs are now also buying fewer loans from the ratings category just above CCC out of concerns that if they are downgraded, they will move down a notch and count against the threshold.
Anticipating “very, very elevated” downgrade rates for B and B-minus rated loans into CCC buckets, Caprio concurred that CLO managers “will probably try to avert the problem” of breaching 7.5 per cent thresholds by reducing their demand for loans ranked just above this level.
But “that in and of itself, before the problem emerges, will actually cause some issues within the loan market”.
The pace of CLO issuance has slowed in recent months, while leveraged loan sales were last year just over a third of what they were in 2021. Even at the top of CLOs’ capital structures, demand has weakened.
“The US big banks have really pulled back” from the top AAA tranches of CLO debt this year, Stroll said, “and have basically been out of the market for a host of reasons”. That “buyer base on the AAAs is just much, much smaller and so the ability to get transactions done is much more difficult”.
Many corporate borrowers refinanced and issued new loans when interest rates were low, loading up on cash and pushing out debt maturities. However, “it is critical to note the majority of US and EU loan demand originates from CLO managers”, Deutsche Bank said in a report last month.
“CLO formation depends on the availability of investors to buy tranches ranging from AAA-rated to B-rated credit quality. And that demand for BBB-rated tranches and below in particular will be severely tested in the next recession.”