With rising concerns about the quality of loans coming to market, CLO managers in both the U.S. and Europe are casting a wary eye on loans rated at the lower end of the single-B scale that are currently outstanding.
When the credit cycle eventually turns, those loans could get downgraded by the rating agencies to CCC, and CLOs, which are the largest buyers of leveraged loans, are not designed to absorb those loans in larger quantities.
“Even with the default environment expected to remain relatively benign next year, loan rating migration to CCC is a risk to CLO par,” analysts at J.P. Morgan, led by Rishad Ahluwalia, wrote on Nov. 20.
An increasing share of loans are being issued near the border of CCC. In the U.S. the volume of B3 term loans is up to $32.3 billion through Dec. 7, making up an 8% share for TLBs in 2018, versus $30.1 billion in 2017 (or 6% share), according to LCD data. In 2016, B3 names totaled only $7.2 billion, a 2% share of the overall TLBs issued.
Meanwhile, issuance of B2 TLBs has risen to nearly $140 billion, for a 34% share so far in 2018, from $104.2 billion, or 22% in 2017, according to LCD.
For first-time issuers, 44% of loans are rated B3, according to Moody’s, and in the third quarter, 55% of all the loans rated single-B were rated B3, marking the first time this year that B3 loans made up the majority of single-B issuance.
Overall, most of the loans outstanding as of Nov. 30 in the S&P/LSTA Leveraged Loan Index were rated B, at 28%, followed by loans rated B+, at 15.7%. Loans rated B– make up 9.4%, up from 8.5% in August.
In Europe, too, speculative-grade companies’ creditworthiness deteriorated this year, with 46.5% of all EMEA ratings now at B2 to B3, versus 37% a year ago, according to Moody’s. Looking at overall new-issue volume, LCD data shows that the share of B3 names rose to 3% (€2.4 billion) in 2018, from 2% (€1.8 billion) in 2017, and nil in 2016. B2 deals accounted for 36%, versus 29% last year.

In Europe, 46.8% of loans in the S&P European Leveraged Loan Index were rated B as of Nov. 30, followed by 18.3% rated B+ and 10.4% rated B–. The single-B portion of outstandings in the ELLI has grown by 37% since the halcyon days of 2007, and by 42% just in the last 12 months.

Downgrades not imminent
Immediate worries among CLO managers about widespread downgrades are still relatively contained based on the current outlook from the ratings agencies. Leveraged finance borrowers in the U.S. on average are seeing about 4.5% earnings growth as economic fundamentals are also still strong, Chris Padgett, senior vice president at Moody’s, said.
This doesn’t necessarily apply universally across all sectors, as Moody’s has negative outlooks on the legacy media, retail, and telecom sectors while having a more positive outlook on the aerospace/defense, solid waste, and energy sectors.
Similarly, analysts at S&P Global Ratings currently have a negative outlook on 141 U.S. issuers that are rated B– or lower. When cross-referencing those issuers with those held in CLOs, S&P Global Ratings found 12 issuers held by managers, including Serta Simmons Bedding, Alphabet Holding Co., Solenis International, and CEC International, that are currently rated B– among other issuers who are already rated CCC+ and below.
Moody’s analysts currently project default rates to be in the low-2% area by the end of next year. In Europe too, default rates are expected to stay in the 2% area, according to Moody’s and Fitch.
Nevertheless, macro-economic uncertainties and a turn in the cycle mean market participants are becoming increasingly concerned with downgrades and the general deterioration of credit qualities.
Most CLOs currently have a limit of 7.5% on loans rated CCC+/Caa1 and below. Any holdings above that threshold, and the excess market value over, starting with the lowest-rated credits, is deducted from par tests such as the junior overcollateralization (OC) tests.
Even before the downgrades arrive, however, CLO managers already are holding some CCC assets in their portfolios. In the U.S., that median concentration has been rising across vintages over the last year, with the highest concentration in 2014 vintages at 5.9%, up from 5.5% last year; 4.4% in 2016 vintages, up from 2.5%; and 3% in 2017 vintages, up from 1.8%, according to data from Morgan Stanley. In Europe, Caa holdings increased by 11 bps in September, to 1.71% across all European CLO 2.0s, according to Moody’s. On a vintage basis, Caa holdings increased for 2015, 2016 and 2017 vintages, led by a 17 bps rise among 2015 deals, to 2.07%.
In Europe, too, some CLO managers are starting to get increasingly nervous about the increase of B2 and B3 rated names and their proximity to CCC territory. “If the economy turns we will see more downgrades and then you are stuck with more CCC names,” said one portfolio manager.
The median European Weighted Average Rating Factor (WARF) for all Moody’s rated 2.0 CLOs is already at post-crisis highs (as of the end of September) at 2,782. This was largely the result of several downgrades that occurred, Moody’s said.
This makes it more difficult to manage CLO portfolios, as managers need to adjust the other collateral quality test levels from the rating agencies matrix, while CLO liability investors are also becoming more cautious. “If a manager is running a WARF test of 2,000, investors quickly ask if they are taking on undue risk and what will happen in a downturn,” said a fund manager. “This makes marketing new CLOs even tougher,” he added.
Accordingly, European CLO managers last month pushed back on single-B loans, forcing Norwegian shipping services company Hurtigruten and fund service provider Vistra to shelve transactions after Moody’s put the firm’s respective B2 rating on review for downgrade because of re-leveraging. This meant CLO managers had to mark down the credit to B3.
Even more worrying, according to some managers, is the fact that loose loan documentation in recent months is allowing borrowers to raise more debt without needing to ask for permission to do so. Such re-leveraging by borrowers increases the risk of downgrades to loans in CLO portfolios even further, managers say.
Not every CLO manager has a problem with WARF tests or B3 credits, and managers say that much depends on what your starting WARF score is. What does count, though, is what they pay.
“There is a price for everything, but what is on the table now isn’t enough,” said one European manager in November.
Indeed, managers note that there is increasing differentiation between rating notices within the single-B range. Among recent deals, for example, B/B3 Global University Systems closed a repricing and add-on at the wide end of talk to leave the firm’s €405 million TLB at E+425, with a 0% floor, in the same week that borrowers such as B/B2 Springer Nature closed a €2.22 billion refinancing and increase at E+325, with a 50 bps floor.
CLOs to handle more CCCs
As a result of the pending downgrades, a number of CLO managers have been issuing vehicles allowing them to hold a much larger percentage of CCC assets.
Managers Ellington Management, HPS Investment Partners, and Z Capital Credit Partners have so far issued CLOs that allow up to 50% of their portfolios to be invested in assets rated CCC+/Caa1 and below. While those CLOs are also paying higher coupons to investors, given the greater risk inherent in the portfolios, managers have said that those CLOs do not need to immediately be invested in CCC assets and can instead be more opportunistic down the line. — Andrew Park/Isabell Witt

Source：LCD