March 19, 2020 - It’s still not pretty out there, and loans still are no exception. This week, we focus on i) how companies are responding to liquidity concerns, ii) credit rating actions and iii) potential knock-on effects on CLOs.
Liquidity first. Unsurprisingly, companies are examining language in – and often drawing on – their loans. Refinitiv LPC reported that some companies are scrutinizing the EBITDA definitions in their credit agreements to see, for instance, whether Coronavirus-related costs could qualify as an extraordinary, unusual or non-recurring charge. More tangibly, a slew of companies have drawn down on their revolvers to lock in liquidity. LCD has tracked $54 billion of recent draws by companies. While institutional term loans generally do not have maintenance covenants, revolvers have “springing maintenance covenants” that trigger at a certain level of drawdown. Covenant Review (CR) reported that the typical revolver covenant “springs” at 35% of usage. However, those revolver covenants generally are set at a high threshold: They are typically first lien leverage tests, half have the covenant at 7x or higher, and 70% have headroom of 2x or more.
Next up is credit. With much of the economy shuttered, corporate earnings and cash flows will decline. Rating agencies have flagged this, identified their industry sector concerns – and have started taking ratings actions. On Monday, Moody’s released a coronavirus sector heat map. First, they defined a baseline and a downside scenario. The baseline scenario, which assumes global coronavirus cases will rise through second quarter, leading to travel restrictions, quarantines, closures of schools, factories and businesses in the most affected countries, would slow U.S. 2020 GDP growth to 1.5%. The downside scenario sees significant increases in cases, public fear it will not be contained, leading to extensive and prolonged restrictions on travel, quarantines and multiregional closures of schools, factories and businesses. In this scenario, U.S. 2020 GDP growth would fall to 0.9%. (Editorial note: The odds of the downside scenario may have risen since Monday.) Moody’s splits its rated companies into “high exposure”, “moderate exposure” and “low exposure” industries. High exposure industries include Auto & Suppliers, Apparel, Consumer Durables, Gaming, Lodging/Leisure/Cruiselines, Airlines and Transportation. Moderate exposure industries include Aerospace, Business Services, Consumer Services, Consumer Non-Durables, Chemicals, Healthcare/Pharma, Manufacturing, Mining, Non-Food Retail, Oil & Gas, Tech Hardware and Wholesale Distribution. Roughly 16% of their rated issuers have high exposure and are immediately vulnerable to negative credit effects under the baseline scenario. The downside scenario could put pressure on around 45% of Moody’s rated issuers.
How do coronavirus pressures affect CLOs? Last Friday, S&P dug into the issue. Though CLO industry diversity shouldcreate some protection, it’s far from business as usual. While CLO holdings typically are granular and diverse, expect negative rating actions across a number of industries reliant on travel or discretionary spending or with substantial cross-border supply chains. Importantly, the ratings of some companies cannot tolerate much of a misstep. S&P notes that about 20% of U.S. BSL CLO assets are rated B-, and about 22% of all B- issuers had negative outlooks or Creditwatch status. These loans are susceptible to downgrades to CCC. (While cash flow slowing dramatically is not good regardless of debt maturity, at least most loans do not have near term maturities.) But one issue for CLOs may be more immediate – and further up the ratings scale. In a recent Salmagundi, Wells Fargo notes that there is considerable discussion about CLO B-/B3 holdings, which might be downgraded to CCC. Excess CCC exposure must be marked to market for the purpose of overcollateralization tests. However, Wells notes that average CLO CCC/Caa exposure is in the 3.5% range, leaving capacity in the typical 7.5% CCC basket room to grow. Instead, Wells points to ratings pressure for BB rated loans. Specifically Hotel, Gaming & Leisure and Consumer Transportation have much higher ratings (generally in the BB- range) and make up roughly 7% of CLO collateral. These sectors may see material downgrades, which could impact CLOs’ WARF and ratings based tests and potentially could constrain CLO investment activities.