The increasing numbers of collateralized loan and debt obligations lending to issuers is leading to more trading volatility in the debt of these companies when they fall into distress, said panelists speaking at the Distressed Debt Investing Forum. Because these structured vehicles have triggers that force them to sell the debt of an issuer that is downgraded, companies that fall into distress will see their debt drop more steeply than in the past.
Peter Lupoff, managing director and senior portfolio manager at Robeco Weiss, Peck & Greer, a distressed/special situations fund, cited Le-Nature's as an example of a company that saw its debt plunge because most investors in the company's debt were CLOs and CDOs that were forced to sell their positions when it was downgraded following allegations of fraud. He said the triggered selling created a sling-shot effect in the trading of the debt.
"The nature of lenders is very different today. The lion's share of debt ends up in CDOs and CLOs," said Lupoff. "In the case of Le-Nature's, all the sellers were CLOs and CDOs. When they all sold at once it created wholesale pressure. The opportunities coming from that are enormous," he said. Lupoff said his fund bought into the debt when it plunged. He said the bank debt traded as low as seven cents on the dollar, but the debt rebounded after hedge funds bought into it with the intention of suing agent bank Wachovia Corp. and its accounting firm for gross negligence, according to traders (CIN, 11/3). The bank debt has since traded up to around the mid-40s. A distressed debt trader said he had never before seen the debt of a distressed-debt company bounce around so much (11/10).
Lupoff added that Le-Nature's debt would have traded differently had banks been the main lenders. He said many banks have workout groups that are more interested in retaining distressed loans as opposed to CLOs that are not interested in holding loans that have gone bad. "CDOs don't have the credit culture that banks have," said Lupoff.
CLOs are also more vulnerable to a downturn in the credit cycle than other types of investors because ratings agencies require them to invest in a broad range of industries. Some of those sectors, such as telecom and manufacturing, are more prone to distressed situations, said John Stark, managing director of Corporate Financial Advisors, a middle-market investment banking firm. "Ratings agencies love diversification. It minimizes risk, but it also guarantees [CLOs] will have problems. Diversification is not always good," said Stark.
One senior manager at a large asset manager said the large supply of liquidity that CLOs have brought to the market has extended the length of the credit cycle. This liquidity, in many cases, has stopped companies' debt from falling into distress. He added, however, that certain CLOs will face financial problems as the credit cycle turns. "There will be enough instances where CLOs won't be able to restructure. There will be potential stress points that people should keep an eye on," he said.
