Over 10% of CLOs Fail Collateral Tests, Putting Payouts at Risk

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(Bloomberg) -- More than 10% of U.S. collateralized loan obligations are now at risk of cutting off cash payments to holders of their riskiest portions amid a surge in downgrades among leveraged loans backing the securities, according to analysts at Nomura Holdings Inc. and Wells Fargo & Co.

About 13% of portfolios failed their so-called junior overcollateralization tests in April, based on a Nomura analysis of roughly 750 CLO deals where payment data was available. Wells Fargo said in a note Thursday that 11% of those it analyzed didn’t pass, and more than half are exceeding standard caps that limit CCC rated loans they can hold to 7.5% of the portfolio, while about 14% breached Caa limits.

CLOs have a battery of monthly compliance tests used to determine payouts to investors of varying levels of priority. But as downgrades to leveraged loans continue to pile up amid the coronavirus pandemic, many managers are now overburdened with more low-rated debt than typically allowed. That’s forcing them to either dump poor performing loans at fire-sale prices, or potentially cut interest payments to investors.

Rating agencies are being much more aggressive in downgrading loans to CCC versus during the financial crisis, and that could result in higher levels of OC breaches,” said Steven Oh, global head of credit and fixed income at PineBridge Investments. “Some of the OC failures are likely to extend even higher up the capital structure.”

While most of the OC test failures were for the riskiest equity portion and lower-rated debt tranches, there have already been a handful of breaches at the AA level, and at least one at the AAA level.

CCC Dilemma

CLOs entered this year with a record proportion of loans rated B- or B3 -- one notch above the lowest junk tier.

Now, as downgrades mount, portfolios are filling up with CCC rated loans. That can force managers to begin marking their worst-performing loans at their trading price, rather than par. That in turn reduces the average value of the portfolio and can trip asset-coverage tests, which causes cash-flow streams to certain investors to get turned off -- a mechanism designed to protect those who purchase less risky portions of the portfolio.

The average CLO saw a 94 basis point drop in its minimum OC cushion, from an average starting position of 392 basis points, according to Wells Fargo.

As more loans are downgraded, so too will the CLO tranches themselves.

Moody’s put 859 CLO bonds, worth $22 billion, on review for downgrade last Friday, including 355 in the BBB equivalent tier and 369 in the BB equivalent bucket. S&P also on Friday placed 155 CLO tranches on negative watch.

©2020 Bloomberg L.P.

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