CLOs: ground zero for the next stage of the financial crisis?
Having boomed over the past decade, these complex securities could be vulnerable if loan defaults spike
In the midst of a global pandemic, emergency rooms across the US have fallen strangely quiet as patients with other illnesses have stayed away for fear of contracting Covid-19. As a result, one of the surprising corporate casualties of the coronavirus crisis could be some of the companies that provide staff for hospitals.
Envision, one of the largest medical staffing companies, completed a restructuring of its roughly $7bn of debt this month as it moved to stave off bankruptcy. This comes less than 18 months after KKR — one of the oldest and largest US private equity firms with more than $200bn of assets — bought the Nashville-based company for nearly $10bn.
The Envision deal highlights one of the stress points in a financial system that is creaking under the pressure of the coronavirus-induced recession. To fund around two-thirds of the acquisition, KKR loaded the company’s balance sheet with junk-rated loans and bonds — a familiar private equity tactic. Those securities provided fuel for one of Wall Street’s least known but most important debt machines: collateralised loan obligations.
The close cousin of collateralised debt obligations that became notorious during the subprime mortgage meltdown over a decade ago, CLOs package up risky corporate loans to back payments on a group of new securities that have cascading exposure to default by any of the underlying borrowers.
To the outsider, they can appear to perform some of the alchemy that was evident in the run-up to the financial crisis, transforming risky credits into securities where the largest tranche is awarded a triple A rating.
“CLOs and the loans underpinning them are ground zero in terms of the vulnerability of this crisis,” says Matthew Mish, a credit analyst at UBS.
The US market — by far the biggest — has expanded from $327bn in 2007 to $691bn at the end of 2019, according to data from JPMorgan, rising in lockstep with the underlying leveraged loan market which has doubled from $554bn to nearly $1.2tn, according to data from S&P Global.
The growth in the two markets is the result of some of the most powerful trends that have reshaped the financial world since the 2008 crisis — reflecting both the rapid expansion of large private equity firms, which have ascended Wall Street’s hierarchy as investment banks have retreated, and the willingness of yield-hungry investors to fund their activities.
In some cases, the PE firms both generate the supply of loans for CLOs through their leveraged acquisitions, while also acting as the manager of CLO structures. And amid such strong demand, the conditions attached to many loans have become looser.
After the initial onslaught in March when the coronavirus pandemic caused a crisis of confidence in credit markets, CLO securities have recovered some ground, helped by the Fed’s aggressive interventions. However, the worry is that further corporate downgrades and escalating defaults could start to unravel sections of the CLO market, in turn prompting a much deeper sell-off that magnifies the broader impact to the economy.
Although proponents of CLOs say the shock absorbers built into their structures will prove resilient, the mixture of complexity, leverage and low credit quality offers some uncomfortable echoes of the last financial crisis.
“CLOs haven’t caused this recession but they will make it worse,” says Megan Greene, a senior fellow at Harvard Kennedy School. “We are on course for a massive debt cycle.”
Despite warnings from analysts and rating agencies that Envision’s deal epitomised a weakening of lending standards, the $5.4bn loan backing the buyout became one of the most widely owned by CLOs.
The onset of coronavirus has seen the price of the loan falling sharply to below 70 cents on the dollar. Moody’s and S&P have downgraded the loan to triple C, a rating reserved for companies close to default and that CLOs are discouraged from investing in.
Envision is not alone. Around a quarter of the loans held by CLOs have already been downgraded, according to Bank of America analysts, and last month rating agencies put more than 1,000 tranches of CLO debt on review for downgrade.
In April, Envision began cutting the hours of emergency room doctors who have been one of the first lines of defence for Covid-19 patients. Bonuses have also been postponed and non-clinical staff were told they would be temporarily furloughed or see pay reductions.
“We are putting ourselves literally on the line, often without the protective equipment we need, to then be told our hours are cut, or that schedules are going to change,” says one emergency room doctor working for Envision in Florida. “It’s frustrating that this large company backed by a very large private equity group can’t find other ways around this that don’t hurt the doctors facing this disease head on.” Envision and KKR declined to comment.
Before coronavirus triggered an unprecedented shutdown of international travel, executives at the New York and London-based investment firms that create CLOs made regular pilgrimages to Tokyo to visit a very important client: Norinchukin Bank, Japan’s largest agricultural lender.
These western managers would fly halfway around the world because the bank commonly known as Nochu, which for nearly a century has managed the savings of farmers and fishermen from Hokkaido to Okinawa, has turned into the whale of the CLO market. In the decade after the financial crisis, it became the single largest holder of the highest-rated, triple-A securities of CLOs, with holdings worth $75bn, according to the bank’s filings.
The Japanese bank will only buy CLO bonds from those it considers to be in the top tier of managers — often the credit arms of private equity houses that issue multiple new CLOs a year. The so-called “Nochu-approved list” of managers that meet its demanding criteria are rewarded with a regular buyer often at a lower price than other investors.
“They do a lot of due diligence — it’s painful getting on their approved list,” says one CLO manager. “But it’s worth it.”
Nochu has reason to be rigorous: the bank has been burnt by structured credit products before. In 2009, the co-operative took what it termed “aggressive write-offs” across its ¥6tn portfolio of asset-backed securities that included CDOs.
“We will continue to monitor the overall market movements because this is the kind of environment that we are in,” the bank said of its CLO investments.
However, for large investors in the top-rated slices of CLOs such as Nochu, there is one statistic that provides comfort: there has never been a default of a senior, triple-A rated tranche of debt issued by a CLO. So far.
In a typical CLO, a thin equity layer sits at the bottom of the structure, awarded the potential for the highest returns but also sitting first in line to absorb losses should the underlying loans default. A series of increasingly highly rated bonds sit above the equity layer, getting increasingly further away from the prospect of defaults impairing the investment.
The vast majority of the debt holds a pristine, triple A rating, which has allowed these securities to draw in a large group of risk-averse investors that might otherwise be deterred from the hazardous loan market underpinning CLOs.
Protections have also been built in, ensuring money is diverted to pay investors in the highest rated tranches of debt first, should the underlying loan market come under severe stress.
Those protections are now being put to the test. While the history is favourable, some investors warn that the current crisis, as well as the state of the loan market, is far different from anything that has come before. Rather than a crisis originating in one corner, such as consumer debt in 2007, the global shutdown is throttling earnings across sectors.
Furthermore, the quality of the underlying loans held by CLOs has sharply deteriorated over the past decade. Moody’s noted that financial covenant protections for investors were at their worst on record just before coronavirus hit. The average number of lower-rated, single B loans held by CLOs was also at a high point.
As coronavirus has spread, sending economies into lockdown and devastating corporate revenues, rating agencies have swiftly begun downgrading loans even further. More than 12 per cent of the loans held by CLOs are now rated triple C — often indicative of a company on the brink of collapse, according to S&P Global.
“The number of loans downgraded in the US and Europe has been at such a harsh and quick pace,” says Geoff Horton, an analyst at Barclays. “It’s unlike anything we have seen in the past.”
Already, many of the protections for senior debtholders have kicked in as CLO managers are forced to contend with the current crisis. “This is severe,” says Pratik Gupta, an analyst at BofA.
Growing risk of default
Typically, CLOs are permitted under their own rules to hold up to 7.5 per cent of their assets in triple C rated debt. If they stay within this threshold then managers of the CLOs can treat the loans they own as if they are worth 100 cents on the dollar.
This is because when a CLO is created, the underlying portfolio of loans is larger than managers need to pay off debt investors. This is known as over-collateralisation. So long as the number of loans that are near to defaulting remains below the 7.5 per cent threshold, the portfolio is treated as though there will be enough money left at the end to pay investors.’
However, if a CLO exceeds its triple C bucket, as many now have, then the lowest priced loans above the threshold are required to be valued at a market price. In a crisis, with loan prices having fallen sharply, this lowers the overall value of the portfolio of loans reported by the CLO. That in turn can impact how investors are paid.
If the value of excess collateral slips by more than a few percentage points, managers typically first cut off 50 per cent of any interest payments on the underlying loans that would have gone to equity holders and use it to buy more loans, with the aim of increasing the value of the portfolio and correcting the breach.’
If the value of the underlying loans falls further, then all money is cut off to equity investors. That money is used not only to pay interest to debt investors but to start paying back the principal of the debt, beginning with the triple A rated bonds.
“Everybody in the CLO business is facing challenges and the challenges start with the triple C bucket,” says Stephen Ketchum, chief executive of Sound Point Capital Management, one of the largest managers of CLOs.
The test is designed as a self-correcting mechanism, reducing a CLO’s debt so that the loans it holds can more easily cover the remaining debt payments to maturity.
But the mechanism is not guaranteed to work. More than 100 CLOs were failing at least one trigger brought on by escalating triple C loans, according to April data compiled by Barclays, with 40 failing tests for their triple B rated tranche or higher — debt that is regarded as investment grade. Twelve have also failed tests up to the double-A rated tranche, according to BofA.
As the quality of loans held by CLOs has deteriorated, it has pushed rating agencies to begin considering downgrading the debt sold by CLO managers, as the prospect that they will be unable to pay back their investors grows. Roughly a third of all triple-B rated CLO bonds are now on review for a downgrade, according to BofA.
“It’s very rare historically for the debt of CLOs not to be paid back,” says Chris Acito, chief executive at Gapstow Capital Partners. “I think we are well on track for that to be a much greater risk.”
It could also still get worse. Investors in higher rated tranches of CLOs — like Nochu — are more sensitive to rating downgrades. They are keen to only hold high-quality assets, or in the case of insurance companies, less willing to accept the higher capital charges associated with lower-rated bonds.
BofA estimates that as much as 40 per cent of all triple B rated tranches in the US are owned by insurance companies. “If you are a ratings restricted investor and downgrades start affecting those bonds, you could see increased selling,” says Mr Gupta.
Despite the looming risks, a broad package of central bank support for corporate credit has helped CLO debt prices lurch back from their lows. Underlying loan prices have recovered as well, rising from a low of 76 cents on the dollar in March to 86 cents on the dollar this week, according to an index run by the Loan Syndications and Trading Association. The Federal Reserve offered little direct support for the CLO market, but broader assurance that the fate of even lower-rated companies is protected has helped put a floor on the recent sell-off.
“The Fed has extended the runway,” says Laila Kollmorgen, a portfolio manager at PineBridge, a fund manager with $96bn under management which invests in CLOs. “We will see downgrades and losses from lower-rated tranches. But is it going to overwhelm us? No.”
In a curious twist, some analysts say the recent degradation in lending standards could end up resulting in fewer defaults. With fewer restrictions on companies that fall into trouble because of looser loan covenants, investors have less ability to force a company into bankruptcy. That could spare CLOs from the worst possible outcomes stemming from coronavirus.
But others are not so sure. At issue is just how long the global economy remains shut down and when companies will recover the earnings they need to repay debt.
“I am not ready to pound the table and say it is time for the credit rebound trade,” says Gapstow’s Mr Acito. “There are too many unknowns.”