The virus crisis is a proving ground for CLOs
CLOs are under acute stress as the coronavirus pandemic wreaks havoc on corporate credit, but the situation presents an opportunity for the market to prove itself to sceptics.
Even before the pandemic sent markets tumbling in March, CLOs were a growing area of concern for legislators and regulators who saw the market’s heady growth as a systemic risk akin to those caused by subprime mortgages and CDOs in the years leading up to the 2008 meltdown.
But there is strong consensus that the structures will hold, protecting senior bondholders even as the stress among leveraged borrowers intensifies.
The main concern is that the growing number of single-B rated names pooled in CLOs will be downgraded en masse — but CLOs will not become forced sellers in the event they breach their limits of triple-C rated loans, and there are mechanisms in place to keep cash flowing to senior bondholders.
What’s more, the corporate default landscape would need to worsen by orders of magnitude compared to what was seen in the 2008 financial crisis. The corporate default rate in 2008 barely scratched the 7%-8% credit enhancement that most post-crisis CLOs are structured with at the double-B level, and would have to be three times higher than that observed in the crisis for triple-A investors to see a principal loss, according to data from S&P.
If CLOs make it out of the pandemic crisis unscathed, which many believe they will, advocates for the asset class will have a strong defence next time lawmakers and regulators begin fretting over the risk they pose to the financial system, having weathered not one but two historic crises in barely over a decade.