September 29, 2022 - We had previously riddled the question: How could CLO AAA spreads and CLO issuance both be around record levels. Well, riddle this no more. While AAA spreads continue to be high, CLO issuance has slowed substantially. But issuance and spreads no longer are front of mind for many CLO-watchers. Instead, focus has turned to the state of the portfolio and the strength of the CLO structure itself. We plumb those issues – after a brief third quarter recap – below.

US CLO issuance fell below $30 billion in the third quarter through September 22nd, LCD wrote, down 33% from second quarter levels and the lowest three-month take since 3Q20. The last three months saw only “new” new issue; there have been no refis or resets since June. This is hardly surprising considering that 3Q2022 CLO AAA spreads averaged 208 bps, up from 163 bps in second quarter, LCD added. Still, after topping out at 226 bps in August, AAA spreads tightened to S+213 thus far in September, Refinitiv LPC calculated. But as R-LPC charted, the top line figures obscure the fact that early in the month established managers priced AAAs around 200 bps; the latter part of the month brought more volatility, newer managers – and materially wider spreads.  Of course, these liability spreads make the asset-liability arbitrage difficult; an eye-opening chart from Nomura has the arb in a near vertical descent from 225 bps in March to 150 bps in September.  While it improved slightly recently due to a softer loan market, Nomura expects the arb to continue to deteriorate as CLO issuance outpaces new lending.

Though pricing always headlines, credit performance is what many folks are scrutinizing. According to Refinitiv LPC, there was $2.8 billion of defaulted debt held across 1836 US CLOs in August, up from $2.5 billion in July.  Meanwhile, Fitch just raised its leveraged loan default rate forecast to 2-3% for 2023 and 3-4% for 2024. This brings the cumulative 2022-2024 default forecast to 7.5%, similar to 2019-2021’s pandemic levels but well below 2008-2010’s 15% levels. While inflation and supply chain disruptions continue to challenge companies, low near-term maturities should mitigate default risk, Fitch added.

But before large principal payments stress borrowers, there’s also the matter of servicing the debt. Bank of America focused on how rising rates and falling EBITDA could affect companies’ interest coverage ratios – and hence their ability to pay interest. BofA noted that the average loan in a CLO portfolio paid roughly 4.25% in coupon interest in 2021; this is projected to more than double to 9-9.5% if SOFR climbs into the 5.5%-plus range. What does this mean for interest coverage? Looking at the 30% of publicly reporting loans in CLOs – more on public reporters later – BofA saw that average ICRs are close to 4.5x and may fall to 2.1-2.3x if interest expense doubles and EBITDA slides 10-20%. BofA further stressed companies with 6x leverage/4x ICR and 7x leverage/3x ICR, reducing their EBITDA by up to 40%. When LIBOR hits 5.5%, the 6x EBITDA/4x ICR cohort saw their ICR fall to 1.1x; the 7x EBITDA/3x ICR cohort slipped slightly under 1x.

Depending on one’s interest rate and economic outlook, this may – or may not – be reassuring. But wait! The 30% public reporters could be larger/better quality than the 70% of non-public reporters. LevFin Insights and data provider Bixby wondered how the non-reporting 70% are faring. Looking at a subset of approximately 500 non-public BSL filers as of June 30, 2022, their median interest coverage was lower – 1.9x reported and 2.4x adjusted – suggesting that these companies might have less ICR cushion.

So, if default rates rise, what does this mean for CLO performance? Barclays researchers built a series of CLO stress test scenarios to assess their performance in a downturn and determine their “break-even” default rates – in other words, the constant loan default rates (and recovery assumptions) that could impair CLO note payments.  Barclays used four default scenarios: 1) Dot-com bubble (prolonged and moderately high default rates); 2) GFC (default rates spike and then come down); 3) COVID 19 (defaults jump to a moderate level and come down quickly); and 4) Severe (default/repayment/recovery rates two standard deviations more severe than seen in the GFC). Barclays’ assumptions for loan repayment, recovery, CCC share and price all aligned with the historical experience.  These scenarios were tested on eight representative deals.

The results: Equity IRR dropped – and was almost wiped out in the excessively severe scenario.  Break- even default rates required a median constant default rate (CDR) of 9% to create the first dollar of loss for BB tranches; 17% was required for BBB tranches. Single As suffered a first dollar of loss at a CDR of 32%; AAs required a CDR of 59% and AAAs were never impaired.  Or, as we interpret it, CLOs performing as intended.

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