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December 07, 2018  

Downgrade Threat Spooks CLO Professionals

Buyers and issuers of collateralized loan obligations are expressing increasing nervousness about the possibility of downgrades within the deals’ collateral pools.

The concerns reflect something of a disconnect in the market. On one hand, industry participants have long worried that strong demand for leveraged loans was making it too easy for weak companies to borrow money while enabling them to reduce investor protections to perilously low levels. On the other hand, healthy economic conditions are keeping a lid on rating agencies’ loan-default projections.

But what if the rating agencies, still facing criticism for hesitating to downgrade subprime-mortgage bonds during the 2007-2008 financial crisis, adopt the view that lax loan covenants justify a wave of downgrades even without strong indications of an immediate downturn?

Some CLO specialists see that possibility as presenting even more near-term risk than an actual deterioration in loan performance, given forecasts that defaults will remain around 2% through 2019. That’s in part because increasing numbers of the companies represented in CLO pools carry ratings slightly above triple-C — a key threshold for collateral quality.

Typically, CLOs carry terms under which the issuers’ loan-trading abilities are greatly diminished once more than 7.5% of their underlying portfolios consist of triple-C-rated assets. Currently, triple-C collateral represents about 4% of the average CLO pool.

While that’s a healthy cushion, Moody’s leveraged-loan specialist Christina Padgett said borrower ratings in CLO pools already are poorer than ever. Companies with “B3” ratings, just one notch above triple-C, accounted for 44% of new leveraged-loan borrowers in 2018 — the highest-level ever.

“There are more ‘B2’ and ‘B3’ [borrowers] than at the peak of the financial crisis,” Padgett said. “The context for that is that in good times, low-rated companies can access the market, because there is a fair amount of investor demand.”

At the same time, a surge in collateral downgrades surely would spook investors.

To that end, there is concern that issuers could sell loans that either have been downgraded or are at risk of downgrades, even though they still are performing as expected. While some such sales might be required to keep exposures to triple-C accounts at appropriate levels, doing so simply to calm investors’ nerves could cause unnecessary trading losses. “Downgrades can make people do short-term things for purposes of window dressing that are not in the best long-term interests of investors,” one buysider said.

In citing the possibility of downgrades, industry participants point out that rating agencies already have issued numerous reports detailing weaknesses in both leveraged loans and CLOs. Those documents have noted increasing debt loads among borrowers, for example, along with expectations of reduced recoveries on defaulted loans during the next downturn.

Issuers are taking that as a sign of concern about aggressive borrower behavior, with one noting that the agencies have responded to additional borrowing by some companies by placing their existing loans on watch for downgrades. “I think the rating agencies are definitely getting a little sensitive to the amount of leverage being put on these deals and, let’s face it, we’re all accomplices,” he said, referring to CLO managers’ continued loan-buying activities.

In October, S&P started publishing a weekly report on all rating actions for loans in CLO portfolios. This week, the only listings were four downgrades.

Still, rating specialists insist that low interest rates and friendly terms could help borrowers stave off both downgrades and defaults. “Over the next year, we expect strong earnings growth,” Padgett said. “I’m surprised the market is worried about downgrades in the near term. We don’t see wholesale downgrades in the coming year unless the economic environment materially changes.”

David Tesher, who heads U.S. corporate-ratings research at S&P, echoed expectations that borrowers will benefit from strong borrowing positions and economic growth into 2019. But in a nod to recent financial-market volatility, he acknowledged that the environment can change quickly.

Why aren’t issuers and investors buying the rating agencies’ assurances? Some point to downgrades of CLO assets during the financial crisis that temporarily choked off payments to equity holders. “That is always their standard answer,” one buysider said. “They aren’t going to do anything . . . until they do it.”

Speaking on a panel at Opal Group’s “CLO Summit,” Omega Advisors portfolio manager Eric Schneider noted that CLOs could be affected greatly if rating agencies suddenly “wake up with a different view” on investor protections among leveraged loans.

Schneider’s remarks came in response to a question from S&P CLO-rating head Jimmy Kobylinski, who moderated the panel, on his views on the state of those protections. “That’s really a better question for you,” Schneider said. The Opal conference took place Nov. 28-30 at the Monarch Beach Resort in Dana Point, Calif.