March 26, 2020 - Companies are being downgraded at a furious rate due to the ongoing Covid-19 crisis. Unprecedented downgrades could limit CLOs’ ability to reinvest (and hence continue act as a stabilizer in the loan market). Below, we discuss recent rating agency actions, what the government rescue packages may (or may not) do, and how this affects CLOs.
Before we get to the grim downgrade scenarios, could the government stimulus plan forestall mass downgrades? Perhaps. Moody’s says they will factor exceptional government support into their credit analysis. For companies that benefit from exceptional government support measures, rating actions will reflect the likely quality of the borrower in the years following recovery from the coronavirus crisis. For companies unlikely to benefit from such programs, Moody’s will tie their rating actions closely to the companies’ current credit profile and refinancing risk. In fairness, Moody’s believes investment grade and strategically important companies are more likely to benefit from this view. However, some companies with “more marginal long-term prospects” may also receive support as the government tries to mitigate the impact of the coronavirus on employment. If support does not materialize for leveraged borrowers, the result may be unfortunate.
On Wednesday, S&P discussed U.S. CLO exposure to negative corporate rating actions. The news was not positive. While CLOs are diversified, a number of key industries (such as gaming/leisure, transportation, hotels, restaurants and entertainment) already are facing severe challenges due to containment measures. Other major CLO sectors, like auto manufacturing, face headwinds due to disruptions in demand and plant closures. Still other sectors – like semiconductors – may not be obvious Covid-19 casualties, but may suffer knock-on effects. So what does this mean for loans in CLOs – and for CLOs themselves? Between March 1 and March 20, there were roughly 140 negative S&P ratings actions on loans held in CLOs. For instance, hotel, restaurants and leisure are the fourth largest CLO exposure, with roughly 79 issuers; more than 50 have had their ratings lowered. As a result of the 140+ negative rating actions, average CLO exposure to loans rated B- and lower has increased to about 30%, up 5.5% in short order. Importantly, the CCC category (including B- loans with negative watch) is just under 7%. Remember that excess CCC exposure – usually over 7.5% – is marked to market, and this can pressure overcollateralization tests. (But, to be clear, the consequence of an OC breach is not liquidation; it is deleveraging of the CLO through paydown of AAA notes, a protective measure.)
Moody’s obliquely references the strength of CLOs in their report on Coronavirus vulnerability heatmap. They do note that some junior CLO notes may be vulnerable, particularly if the CLO has high exposures to Coronavirus-sensitive industries or if overcollateralization is thin. However, Moody’s also notes that AAA tranches have significant protections from overcollateralization and diversion of cash flows to repay AAA if OC tests are breached. As a result, Moody’s puts a few CLOs in their “High Vulnerability” category and “most CLOs” in their “Moderate Vulnerability” category.
Fitch also will apply a stress scenario to CLOs. In the stress analysis, Fitch will adjust the ratings down by one notch for issuers in seven highly impacted industries (i) airline related, ii) energy, oil & gas, iii) gaming, leisure & entertainment, iv) lodging & restaurants, v) metals & mining, vi) retail and vii) transportation). These downgrade tests will stress the CLO portfolios and, if the indicative portfolio analysis does not pass required rating thresholds, the CLO notes will be placed on ratings watch negative (RWN). After that, notes on RWN will be reviewed and resolved individually. Bottom line, Fitch thinks CLO notes will be mostly resilient, particularly senior notes.
Net-net, without government support, expect to see significant corporate stress, ongoing downgrades and the potential of CLOs losing their ability to reinvest (and stabilize the whole loan market).