Eyeing downgrades, CLO issuers prep looser terms

A slowing economy is likely to weigh on US corporates, leading to rating downgrades that could induce CLO managers to sell loans on the basis of failed overcollateralization or weighted average ratings tests. A small but growing handful of new issue deals are already taking active bets on such downgrades and incorporating a bigger bucket for downgraded debt or accommodating a hybrid pool of bonds and loans.

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“The big concern among investors these days is the risk B3 loans getting downgraded to C and potentially triggering a sale from the CLO portfolio,” said one CLO issuer. “Equity investors are especially worried about a downgrade risk diverting cash straight to debt holders.”

Rating agencies also expect that ratings migration will be greater in the coming downturn given the increased prevalence of lower grade loan issuance.

“Around 44%-45% of new issuance in the loan market was B3,” said Dev Chatterjee, managing director at Moody’s Investors Service. “That’s an increase versus years past. Overall outstanding ratings in the B3 area is 27%-28% but B3 is dominating the new issue market. You expect more ratings migration as it’s generally more volatile at lower ratings.” 

Some managers are taking a proactive approach to positioning for these downgrades.

In a CLO that was priced on Friday, Ellington Management came to market with a deal arranged by Barclays that gave the loan portfolio a larger triple-C bucket than is usually seen. The triple-A notes were priced at a spread of 184bp over Libor, according to a source familiar with the deal.

Most CLOs have a set bucket for triple C-rated credits of around 10%. In the event of downgrades, some managers may need to trade out of these higher risk loans or risk failing their triple-C test limit. Ellington’s managers would then plan to target these risk assets sold off in the secondary at a discount.

Ellington pioneered this space, but a few other managers have waded in as well. Z Capital Partners and Highbridge Capital Management both have issued deals that seek to buy lower rated loans in a selloff.

Hybrid CBO or CDO deals that accommodate holdings beyond senior secured loans are also surfacing as savvy investors look to buy corporate assets on the cheap amid a potential downturn.

“In general, you’re seeing more deals that want to swoop in and be able to buy cheap risk assets in the event of a downturn,” said another CLO manager.

However, according to Moody’s analysts, some managers are getting wise to these plans and are putting looser, more creative terms into their deal structures to give themselves greater flexibility to carry distressed debt inside the CLO vehicle.

“Many CLOs have exceptions for what’s considered Caa debt, and in practice, CLO managers are working in terms in deals that give themselves effectively a greater basket to accommodate Caa holdings,” said Al Remeza, a Moody’s associate director.

He downplayed the notion that CLOs will be required to sell off loans from their portfolio in order to conform to deal covenants, a potential fly in the ointment for those managers looking to buy triple-C loans on the cheap.

“In general, the CLO structure does not force the manager to sell assets. You did see mutual funds selling off assets in the fourth quarter and driving the market down. But CLOs are not required in any form to create that kind of selloff,” Remeza said.