As coronavirus hits leveraged loan market, CLOs wary of downgrades

Further evidence that downgrades are the main concern of secured loan bond managers in Europe has emerged, with JP Morgan releasing the latest results from its CLO survey (which has been running since 2009) showing that “nearly half ( 45% of participants rated loans downgrades as the biggest concern and 26% of participants voted for defaults.”

While a wild wave of downgrades has yet to emerge in Europe, those who have made a difference – and gamers are aware that it’s only a matter of time before downgrades pick up speed.

CLOs are an essential building block for investors in the European and US leveraged loan markets. They have thresholds as to how much low-rated debt they can hold.

JP Morgan says CLO managers’ concern makes sense, as “test failures can occur on the majority of CLOs if an additional 4-5% of portfolio loans are downgraded, triggering restrictions on managers.”

As for other responses on top concerns, JP Morgan adds that 11% of its respondents voted for CLO rating downgrades, 10% for CLO warehouse liquidations, 7% for CLO stock shutdowns and only 1% for a CLO default event (this survey was conducted from March 24 to 26 with 51 respondents).

Barclays Research analysts also looked at loan downgrades, commenting in an article on Friday – titled ‘Downgrades at the Races’ – that “we expect European loan downgrades to worsen significantly. We have already started to see this play out with loans in the European Leveraged Loan Index (ELLI) being downgraded at a faster rate since the start of the year than at the same time in 2019. We We have 20 downgrades by S&P since the start of the year, compared to 6 since the start of 2019. Similarly, we have 12 downgrades by Moody’s since the start of the year, compared to 3 in 2019. TOTAL TO DATE .”

So far, the number of downgrades to triple C – which has the greatest potential to damage CLOs – has been limited.

Roll call demoted
Looking only at S&P Global Ratings stock, the chart below shows all triple-C downgrades, but of these only Hurtigruten is part of the European Leveraged Loan Index.

S&P Global Ratings earlier this month, in an article titled “European CLOs: assessing the credit effects of COVID-19“, pointed out that his downgrades in the triple C category (along with the number of CLOs that hold them) were as follows: Hurtigruten (45), Code (18), and Travelex (2). Companies that have been pushed into territory B are view (72), cassini (40), Comet (7), and Amphora (6).

Meanwhile, a first look at the composition of ELLI ratings still shows little change this quarter. The proportion of voters rated CCC+ and below in the ELLI is currently 3.56%, up slightly from 3.15% in December (note this compares to 2.79% in December 2008). Barclays adds that “the CCC and Caa buckets [of CLOs] are still relatively weak, with average Caa and CCC buckets at 2.4% and 1.8% in European CLOs, respectively.”

SNL picture

Rather, much of the action takes place in the simple B cohorts, mostly at B-, with the share of B+ credits in the ELLI decreasing by 0.58%, to 21.1%, while the share B and B- credits increased by 0.01% and 2.52%, respectively, to 42.88% and 14.04%.

According to Barclays, this trend is reflected in the activity of Moody’s, whose “lower-rated stocks have been even more concentrated at the B2 level, further increasing the B3 exposure of the loan market”. Barclays adds that “the number of loans on negative watch remains relatively low. However, this also appears to be accelerating, with the majority of loans on negative watch by S&P (8) placed there in March, along with most loans under negative watch by Moody’s (5).”

Impact of downgrades
While the number of downgrades remains fairly low, they are accelerating – and the few that have taken place so far are having an effect. Barclays notes that “due to increased downgrades and assets placed on negative watch or outlook, European WARF CLOs have continued to rise. Median WARF scores are now around 2,980, with three vintages currently above to 3,000 (2013-2015). In some context, a WARF of 2,720 equates to a B2-rated portfolio and 3,490 to a B3-rated portfolio.”

WARF stands for Weighted Average Rating Factor.

All of this means that CLO managers “will have to be even more proactive in managing rating bands in the future. Especially if downgrades continue, with more concentration around the B3 level, managers could see WARF scores increase. at an even faster rate with the CCC slices filling up more,” adds Barclays.

With that in mind, JP Morgan says its survey results show “there is consensus on selling autos, energy, gaming/lodging/leisure and retail, while buying is more mixed, with technology, cable/satellite and healthcare receiving the most buys.In terms of percentage in each sector, metals and mining and retail are both voted 100% to sell, while cable/satellite, financials, food and beverage, paper and packaging, telecommunications and utilities are both voted to buy 100%.

Still, cash balances aren’t huge, according to JP Morgan. “The majority of responses (51%) are in the Low (0-5%) category, but the proportion with a moderate cash balance (5-10%) has increased to 42% from 33% in the first quarter,” adds the bank. “The High/Very High share (10%+) reached its second lowest point since Q1 2012. The Add/Reduce ratio remains low, around 3.4x, the second lowest level since 2010, and although there is a sharp drop in the number of investors looking to add risk, [the] the majority (52%) of investors expect holding risk to have reached the highest level in our 10+ years of surveying.”

This analysis was written by Luke Millar, who oversees European leveraged finance coverage for LCD in London.

Priscilla C. Carnegie