April 2, 2020 - What are potential economic scenarios in this rapidly evolving Covid crisis – and what do they mean for companies and CLOs?
Moody’s gamed out Covid’s impact in several scenarios. Scenario one sees a severe but short-term economic impact as efforts are made to contain the virus. This leads to a short, sharp recession in 2Q20, weakness in 3Q20 and recovery in 4Q20; U.S. unemployment jumps from 3.5% today to 6.1% in February 2020; and the U.S. speculative grade default rate (loans and bonds) climbs from 4.5% today to 7.7% at YE2020 and 7.8% in February 2021. That is the rosiest scenario. The medium scenario is equivalent to the Financial Crisis. In scenario two, the coronavirus continues to spread and containment continues, creating a 12-month recession. In this scenario, U.S. unemployment climbs to 10% by the end of August, and the U.S. spec-grade default rate hits 16.2% at year-end and 18.6% next February. That’s the medium scenario. In the third scenario, virus containment is very challenging, economic activity is severely curtailed and confidence collapses. Here, the U.S. unemployment rate hits 15% in May and U.S. spec-grade default rates hit 18.4% at year-end and 22% next February.
Narrowing from spec-grade to loans, Fitch sees the institutional loan default rate climbing to 5-6% by YE 2020 and 8-9% in 2021 – if there’s a v-shaped recovery. A prolonged recession could push the default rates into the double digits.
How do these macro views inform ratings actions? Harshly. As of March 27th, Fitch globally had downgraded 30 spec-grade companies by one or two notches and had placed another 33 on outlook or negative watch. Likewise, S&P had revised the outlook, downgraded or placed on negative watch 350 North American companies; 286 were spec-grade companies. On Wednesday, Moody’s announced March downgrades – and some quick math suggests they placed 151 non-IG ratings on review and downgraded 257 one-notch or more.
How have companies responded? Where possible, they are taking action by locking in liquidity. Through March, LCD tracked more than $175 billion of revolver draws and nearly $16 billion of incremental delayed draw capacity; non-investment grade and unrated borrowers accounted for 46% of revolver draws. Refinitiv adds that more than $74 billion of new or incremental facilities were inked in first quarter as companies proactively locked in liquidity.
It’s critical that non-investment grade companies – that employ millions of people – get the liquidity they need to survive. But even if companies survive, CLOs will still feel some pain. On March 31st, S&P described the impact of company downgrades on the 410 CLOs in their 2020 Index. U.S. BSL CLOs have seen 14% of their collateral downgraded or placed on negative watch since early March. As a result, the CCC baskets have more than doubled in March to 8.4%; CCC exposure over 7.5% typically must be marked to market (but not liquidated!), and this is reducing the junior OC cushion. In turn, there also have been ratings actions on CLO notes themselves: As of March 30th, 59 tranches across 39 S&P rated BSL CLOs have ratings on Creditwatch Negative.
Moody’s expanded the CLO analysis by describing rating actions of holdings in i) highly vulnerable sectors and ii) moderately vulnerable sectors and then cross-referencing that work with iii) B3 rated assets and iv) near-term maturities. This research somewhat reduces the litany of woe. First, CLOs have an average of 14% of their collateral in highly vulnerable sectors and another 53% in moderately vulnerable industries. Still, this doesn’t mean CLOs will see a rash of defaults in their investments; there is just 0.6% of par value that i) is rated B3 and below, ii) is in highly vulnerable sectors and iii) matures in 2020 or 2021. Expand the analysis to moderately vulnerable sectors and this deadly intersection remains just 1.1%. Next, Moody’s stress tested WARFs (weighted average rating factors) in CLOs by i) assuming a two-notch downgrade of companies in highly vulnerable sectors and ii) additionally assuming a one-notch downgrade in moderately vulnerable sectors. Average WARF worsened by 9% in scenario one and by 25% in scenario two. Importantly, even scenario two is “less bad” than WARF deterioration in the financial crisis.
With all the pressure on companies, some CLOs are likely to go static and start deleveraging by repaying their senior notes. However, it is critical to understand that this is a protective feature for senior debt – and not a bug! – in CLO structures.