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October 25, 2019  

CLO Loan Parameters Feeding Disruption

Amid signs of stress in the leveraged-loan market, spreads are widening for certain junior collateralized loan obligation notes.

The problem is, the CLOs’ own portfolio-management guidelines are magnifying the effects.

Among double-B-rated CLO notes, which typically are senior only to the deals’ equity pieces, new securities with five-year lives are selling at spreads in excess of 800 bp over three-month Libor — at least 15 bp wider than late-September levels and 25 bp wider than late July. By contrast, higher-rated securities generally have held their value or even rallied.

The widening at the double-B level largely tracks a pattern in which increasing corporate downgrades and defaults have caused some leveraged loans to lose value. But for loans, the recent spread widening has been limited largely to single-B-rated accounts — with double-B spreads actually narrowing.

The divergence in part reflects collateral-quality requirements built into CLOs, including terms that typically limit the deals’ holdings of triple-C-rated assets to 7.5% of their collateral. Issuers have been gravitating toward double-B-rated exposures partly out of concern that weakness among corporate borrowers could cause downgrades of single-B loans, which could cause their “triple-C buckets” to overflow. Should that happen, built-in protections for senior bondholders would force diversions of principal and interest away from the CLOs’ most-subordinate classes.

While some issuers surely are temped by today’s larger returns on the weakest single-B loans, their deal terms additionally contain disincentives for them to buy assets at steep discounts to face value. If a CLO manager purchases a loan for more than 80 cents on the dollar, it can count the full par value of the position toward calculations of the deal’s continuing strength — even if the price later sinks to less than 80 cents.

For a loan purchased at less than 80 cents, the issuer must track the account’s market value instead. The affected calculations include measures of over-collateralization, where a shortfall would force a diversion of principal and interest away from equity holders.

That risk has fed back into the decline in “junior-mezzanine” CLO values. So too has the possibility of a CLO downgrade when the market values of a deal’s underlying loans decline. On Oct. 21, Moody’s downgraded $7 million of mezzanine CLO notes issued in 2015 by a 50/50 joint venture between Jefferies and MassMutual called JFIN, citing par loss and credit deterioration among the deal’s receivables.

The issuers’ buying habits additionally have been influenced by pressure from investors. “If a CLO has too many loans below certain price bands, the market looks increasingly unfavorably on a manager, and on the most sensitive or leveraged classes of the CLO,” said Steven Abrahams, a senior managing director at Amherst Pierpont. “For that reason, beyond downgrade risk, there’s a significant incentive for managers to avoid loans with a potential to sink in price.”

The situation is denting demand for CLO equity as well. That’s because investors in those pieces receive no principal but are entitled to any cash left over after paying more-senior noteholders. Thus, they stand to get less when more capital goes toward paying junior-mezzanine holders.

One source said many issuers have responded by retaining their deals’ equity pieces with an eye toward refinancing the transactions’ mezzanine notes if spreads eventually narrow. Some also are seeking flexibility through terms that would exclude certain loans from their triple-C exposure limits.

The effects of CLO issuers’ buying preferences have been especially pronounced because the deals currently hold 72% of outstanding leveraged loans — an all-time high according to S&P.

And with CLO issuers crowding into positions with ratings of at least double-B-minus those accounts represented 60% of loans that traded at more than their par values in September, according to the Loan Syndications and Trading Association. That’s up from 35% at midyear.

CORRECTION (11/1/19): This article has been revised. The original version misidentified Jefferies as the sponsor of a collateralization downgraded by Moody’s. The deal was issued in 2015 by a 50/50 joint venture between Jefferies and MassMutual called JFIN.