Post-Crisis CLOs Beat 2020 Stress as Only 2 Junk Slices Default

(Bloomberg) -- The credit market’s hottest product, collateralized loan obligations, are headed toward a record-setting year of sales. Investors will be happy to know that the complex instruments have performed remarkably well over the last 10-plus years, despite challenges such as the 2020 Covid-19 pandemic and related economic shutdowns. 

Out of more than 1,300 U.S. CLO transactions rated by S&P Global Ratings from 2010 through the second half of 2021 -- or nearly 11,000 tranches across the rating spectrum -- only two tranches have defaulted as of mid-August. Those slices were originally rated junk, with grades of BB and B.  

“So far, only a modest number of U.S. CLO tranches are expected to default coming out of the 2020 economic downturn, mostly limited to the junior-most tranches within the capital structure of the CLO,” S&P analysts said in a study released earlier this month.

The research looked at more than $860 billion S&P-rated “CLO 2.0” transactions -- or the generation of new issuance that arose in the aftermath of the Great Financial Crisis, starting in 2010.  

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The new deals had many differences from pre-crisis, or “CLO 1.0” offerings, including: boasting more investor protections in the form of credit enhancement, excluding risky non-loan collateral such as high yield corporate bonds, and limiting CLO manager’s ability to trade after the reinvestment period. The deals in the study included refinancing and reset activity.

“While there was a downturn in the energy and commodities sectors in 2015 and 2016, the CLO 2.0 generation of transactions hadn’t seen a full-blown recession until the 2020 pandemic-related downturn,” the analysts said. 

In comparison, for CLO 1.0 deals -- those rated starting in the mid-1990s through 2009 -- out of around 800 CLOs rated by S&P, or more than 4,300 ratings, just 40 defaulted, 15 of which began life with an investment-grade rating. No AAA rated CLO tranche has ever defaulted in the entire history of the market, the S&P data show.

More to Come?

In addition to the two defaulting CLO 2.0 tranches, S&P also saw a small number of tranches from seven CLO 2.0 transactions that the company views as likely candidates for future defaults.

They were all originally rated in the BB or B range, and have already been downgraded to the CC or CCC- ratings tier, the data show.

“The CLOs from which these tranches come from are earlier vintage 2.0s that experienced both the energy and commodity downturn in 2015-2016 and the pandemic-related downturn in 2020,” the analysts said.

Read more: CLO New Issue Sales Set Monthly Record in August

New-issue CLO sales this year currently stand at around $110 billion, and broke the $100 billion mark at the fastest pace on record, according to data compiled by Bloomberg. Moreover, August posted an all-time monthly high for CLO issuance, with more than $18 billion sold so far, the Bloomberg data show. The global CLO market has crossed the $1 trillion mark in outstandings. 

The CLO market has been buoyed by investors’ thirst for yield, as well as higher demand for floating-rate debt, as many market participants expect rates to continue rising, making fixed-rate bonds less attractive. 

The market last year was helped by support from the Federal Reserve to the riskiest companies -- those that issue leveraged loans -- as well as CLO portfolio managers trading out of perilous credits, protections built into the deals and a lower number of loan defaults than anticipated.

Relative Value: Agency RMBS

• Goldman Sachs Asset Management remains underweight agency MBS, given the deteriorating demand-supply picture, analyst said in a recent research note
• Supply is set to rise given expanding mortgage financing availability. Meanwhile, bank and foreign investor demand has moderated from record high levels observed in early 2021 as investors look ahead to reduced Fed purchases

Quotable

On the CLO market’s transition away from Libor and differences in deal documentation: “Will this lead to a fractured market with a broad range of different outcomes? I do not think so,” said Hsiang Lim, the global head of CLO new issues at Deutsche Bank. “CLO managers are generally repeat issuers who are very cognizant of the need to be able to continue attracting debt investors for future issuance. This provides an incentive for the market to seek to coalesce around a largely common standard, as opposed to pursuing unique documentation interpretations.”

What’s Next

ABS deals in the queue for next week include First Help Financial (subprime auto) and Carvana (non-prime auto).

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