CLO experts fear wave of downgrades over next three years

Market players speaking on a panel on day two of ABS East were sounding the alarm on the possibility that a wave of downgrades could hit CLO collateral over the next three years, testing the market’s ability to withstand an influx of triple-C loans.

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The risk of 10%-20% of collateral held in CLOs becoming triple-C rated is “a real possibility over the next three years,” said Thomas Majewiski, managing partner and founder at Eagle Point Credit Management.

Several participants noted the growth of the single-B market over the past few years, and the inclusion of rating agency documentation commenting on the possibility of a downgrade.

“That migration to single-B isn’t accidental,” said Steve Wilkinson, senior director at S&P Global Ratings. “In order for the [private equity] firms to make their equation work, they’re targeting single-B at a rating level.”

Neha Khoda, leveraged loan strategist at Bank of America Merrill Lynch, said that the presence of retail borrowers in CLOs may add to the risk of downgrades.

“Participant of retail inevitably increases the volatility in the loan market,” said Khoda.

The 2008 level of triple-C rated collateral peaked at around 15%, according to rating agency data. Participants questioned whether the market will be able to absorb that amount of new non-IG credit, particularly if the downgrades happen in quick succession.

Downgrades in CLOs now outnumber upgrades three to one, according to the panel, but this is not expected to lead to a wave of defaults.

“That is a concern, but I think the thing to remember is that the default risk is still low,” said Khoda. “We are just in a very different default cycle, this is unprecedented.”

“We certainly had a high triple-C rate in 2008 and 2009, and most CLOs never missed a payment to the equity through that,” said Majewiski.

Financial maintenance covenants have also been decreasing over the past decade, with covenant-lite loans now making up 80% of the market, up from around 60% in 2013 and from close to zero in 2006.

“I would need more than two hands to count the number of companies which would have defaulted in the last year had they had ongoing financial maintenance covenants,” said Majewski.

Despite the warnings, the panel and audience both agreed that the downturn is unlikely to hit before the end of 2019.

“There is no imminent default cycle that we see on the horizon,” said Asif Kahn, managing director and head of CLOs at MUFG.

The audience, polled at the beginning of the panel, was almost equally split between predicting the downturn to occur either in 2020 or in 2021, with only 10% pointing to 2019 or 2022 as the year the cycle will turn.

“Cycles don’t die of old age, they get killed,” said Majewiski.

Panellists said that central banks were likely to try and delay the turn of the credit cycle as long as possible. This could lead to an influx of so-called “zombie companies”, which are held back from the brink of default by central bank easing policies.

“It think the biggest lesson is that as long investors you need to be ready for recoveries and credit losses,” said Khoda. “As long as we are prepared for that, as long as the securitized world is prepared for that, I think we are okay.”