These CLOs Lie in Wait for the Powder Keg to Blow

Brian Chappatta 

BloombergOctober 25, 2019

(Bloomberg Opinion) -- Ask fund managers about their worst nightmare, and almost surely it's some variation of being a "forced seller" in a weak market. Investors get panicky, rush to pull their money out and managers have no choice but to offload securities at fire-sale prices to raise cash.

One of the benefits of running a collateralized loan obligation is that the constant specter of redemptions is nonexistent. The money is raised up front by selling tranches of bonds split up by credit rating, and then the manager purchases a swath of leveraged loans to pay those investors. The CLO securities can change hands in the secondary market, but the manager doesn't have to worry about being on the hook for unloading loans if some people want out.

And yet, even CLO managers can't entirely escape forced selling. As a recent Bloomberg Businessweek article described, most of these vehicles are prohibited from having more than 7.5% of their portfolio tied up in loans rated triple-C or worse. During the heights of the economic expansion, that hasn't been an issue. But given that almost one-third of leveraged loans, by some estimates, are just a downgrade away from triple-C, even a modest slowdown could be enough to create a snowball effect of sorts. 

In such a situtation, "the CLO managers will be in a bind: either unload that debt, and fast, or risk tripping ratings triggers that prevent them from making some payments to their investors," Bloomberg's Lisa Lee, Sally Bakewell and Katherine Doherty wrote. Given that CLOs own more than half of the leveraged loans outstanding, and big mutual-fund managers like Eaton Vance Corp. tend to stick to higher-quality obligations, it's easy to envision holders of triple-C loans having to sell into a vacuum, causing spectacular price drops. Credit to Lee, Bakewell and Doherty for this illustrative chart:

Obviously, a large-scale collapse into triple-C ratings hasn't happened yet. But cracks are beginning to emerge in the riskiest corners of the debt markets.

And Andrew Curtis is lying in wait.

Curtis is the head of Z Capital Credit Partners, which has issued two CLOs that can invest up to 50% in triple-C rated loans. Along with Ellington Management Group and HPS Investment Partners, the firm is effectively betting that when the inevitable spate of downgrades comes, its analysts can sift through the wreckage to find ultra-cheap debt from companies that are strong enough to pay back what they owe.

I've been skeptical of this approach in the past, comparing it in July to catching a bunch of falling knives. At best that will usually come with a few deep cuts.

However, since then, the Federal Reserve has cut interest rates twice and looks likely to do so again next week. This easing, which was more aggressive than markets expected, increases the likelihood that if the economy is truly on the verge of a slowdown, the central bank's preemptive actions might have curbed its severity. In that kind of situation, companies with leveraged loans might still struggle and have their ratings downgraded to triple-C, but not necessarily hurtle toward default and restructuring. Survive and pay is something of an ideal scenario for these highly flexible CLOs.

When asked if that aligns with his view of the markets, Curtis agreed. "In some ways, for these vehicles, potentially the best environment is where you have a slowdown but not a descent into full-blown recession. That slowdown drives weakening, but not terribly weak financial performance. That in turn drives volatility in prices and downgrades, which in turn drive further price volatility."

No one is rooting for a downturn, of course. "People love to talk about this being the beginning of the end, but we're not convinced that's the case," Curtis said. Still, for investors, it pays to think ahead for what types of strategies might work well if economic conditions change.

Leveraged loans, while risky by nature, are nonetheless senior debt obligations of a company. CLOs typically diversify across 100 or more borrowers. In the case of the Z Capital Credit Partners's flexible CLOs, the triple-A tranche is 50% of the structure, less than normal, adding an extra buffer for losses. Add in the fact that they have the option to snipe their favorite triple-C rated loans at potentially bargain-bin prices, and almost never have to succumb to forced selling, and you can start to see the appeal.

"People view vanilla-type, regular-way CLOs as safer than these newer deals, but vanilla deals have higher leverage, are all forced to buy the same covenant-lite slice of the loan market, and their structures push them to sell at the same time, which we believe makes them more dangerous," Rob Kinderman, head of credit strategies at Ellington, said in July.

I'm not sure I'd go so far to say that CLOs that own lower-rated loans are actually less risky. But they're not the "powder keg" that worries investors. That stems from the vicious cycle of forced selling, which prevents companies from obtaining new credit or refinancing, which could vanquish them entirely.

By contrast, while the overall CLO market has more than doubled to $660 billion since 2010, there's only about $3 billion tied up in CLOs that are more lenient about owning triple-C debt. That's paltry in comparison to the amount of leveraged loans on the brink of falling into that lower rating tier. Curtis said he and his team analyze companies as they veer toward a downgrade, rather than after, so they know which loans to buy and which to avoid if prices move sharply lower.

Even now, Curtis said his CLOs have only about 15% invested in triple-C loans. He's waiting for bigger disruptions that push prices even lower while also being cognizant that the single-B rated debt he owns could also fall into the triple-C tier. "You don't want to utilize the capacity too early because then you don't have the flexibility when the market is most interesting," he said.

Right now, the consensus is that low-rated debt is concerning, but it's still well short of outright panic. If the CLO powder keg does blow eventually, better to be safely off to the side picking up the pieces than embroiled in the volatility.