October 8, 2020 - On Monday, the SEC released a report, US Credit Markets: Interconnectedness and the Effects of the COVID-19 Economic Shock, which included a chapter on CLOs and leveraged loans. We’ll dig into the report below, but let’s start with the SEC’s conclusion: “[w]hile these markets [loans and CLOs] have fared reasonably well thus far, the disruption brought on by the COVID-19 economic shock is still ongoing and their risk assessment may evolve in the future.”
While the conclusion was cautious, the overall report was nuanced and generally positive. First, the SEC noted the growth of the loan and CLO market and partially attributed it to the low interest rate environment of 2014-2018 and incentives to reach for yield. Growth notwithstanding, $1.2 trillion of loans and $700 billion of CLOs are a relatively small portion of debt outstanding in US markets. However, the SEC observed that connections across a wide range of participants (often through CLOs) expose levered lenders (like banks and insurance companies) to higher risk borrowers. The SEC attempted to disentangle those connections and measure the risks that they might bring.
Drilling into CLOs, the SEC observed that banks and insurance companies primarily hold the senior tranches; thus, if losses in CLOs are concentrated among the equity tranches, the macroeconomic impact would be limited. So the question is: Will Covid-19 create losses in higher rated tranches?
Losses in CLO tranches generally would come from higher defaults, lower recoveries and default correlations. But if defaults become highly correlated (because of an economic shock that affects many borrowers), the probability of senior CLO tranches incurring losses would increase.
And, of course, the reality is that Covid-19 has worsened the credit environment. Corporate downgrades have been widespread and the share of B3 and below loans has increased to 30% of CLO holdings. Meanwhile, the leveraged loan default rate has topped 4% and is expected to increase further. The SEC observes that the “nature of the COVID-19 economic shock suggests all three – higher default rates, greater default correlations, and lower expected recoveries – going forward.”
However the SEC also enumerates the protections built into CLOs. First, the assets are diversified by obligor and industry, theoretically reducing default correlations (though a global pandemic may well increase default correlations across seemingly uncorrelated industries). Second, CLOs match asset-liability maturities (limiting run risk) and interest rates (limiting interest rate risk). Third, senior noteholders are protected by monthly cash flow and collateral tests, and the ensuing diversion of cash flows from subordinated tranches if the CLO’s portfolio is under stress. Fourth, while banks and insurance companies are large investors in CLOs, a variety of institutions invest in CLOs, limiting the risk of market disruption due to the exit of a single entity.
Weighing these factors, the SEC ultimately suggests that AAA rated senior tranches will not incur losses unless economic conditions worsen dramatically – like 35% defaults/0% recoveries. But the final word is, of course, caution: “[w]hile [CLOs and loans] have fared reasonably well thus far, the disruption brought on by the COVID-19 economic shock is still ongoing and their risk assessment may evolve in the future.”