CLOs Have Seen Only Five Defaults in a Decade
CLOs Have Seen Only Five Defaults in a Decade
(Bloomberg) -- Investors can’t get enough of leveraged loans that get packaged into bonds, and a report that came out this week gives an inkling as to one reason why: the securities almost never default.
Among pieces of collateralized loan obligations initially rated investment grade, zero have defaulted over the last decade, according to S&P Global Ratings. Out of more than 1,300 U.S. CLO transactions rated by the firm from 2010 through the third quarter of 2021 -- including about 11,400 securities across the rating spectrum -- only five portions have defaulted as of Jan. 1, 2022. Those slices were originally junk rated, either at the BB or B tier. And securities from five deals are at imminent risk of defaulting, the firm said.
“Since the asset class emerged more than 25 years ago, CLOs have shown resilient performance through multiple economic downturns,” S&P Global analysts led by Stephen Anderberg said in a Wednesday report.
U.S. CLO sales reached an all-time high last year of $184 billion, and it’s not just because of investors’ sense that the securities are relatively safe. The instruments also offer relatively high yields, and pay floating rates, meaning they offer protection against inflation.
Shock Absorbers
The securities also benefit from having shock absorbers built in, the S&P analysts said: when the loans backing a deal start to suffer, the investors in the riskiest securities, known as equity, absorb losses first. In those times of stress, the holders of securities rated AAA are last to take losses, meaning they have the most protection.
The research looked at more than $900 billion of S&P-rated “CLO 2.0” transactions -- or the generation of new issuance that arose starting in 2010, in the aftermath of the 2008 financial crisis.
The new deals had many differences from pre-crisis, or “CLO 1.0” offerings, including: more investor protections in the form of credit enhancement, mostly excluding risky non-loan collateral such as high-yield corporate bonds, and limiting CLO managers’ 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, and a small number of CLO 2.0 tranches have now defaulted,” 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.
Future Defaults?
In addition to the five defaulting CLO 2.0 portions, S&P also saw a small number of tranches from five 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 somewhere around CC or CCC-, the data show.
“While these tranches haven’t yet defaulted, they have experienced downgrades to their current ratings due to significant credit deterioration, and the current ‘CCC- (sf)’ and ‘CC (sf)’ ratings assigned reflect our view that it is unlikely the notes will get repaid in full by the CLOs‘ legal final maturity dates,” the S&P analysts said.
Demand for the instruments is expected to remain strong this year. Earlier this month Morgan Stanley said that buying CLO equity remains one of the firm’s favorite trades for securitized products this year.
Relative Value: Agency MBS
- Goldman Sachs Asset Management remains underweight agency MBS given reduced Fed buying, high interest rate volatility, and raised prospects for balance sheet runoff to commence later this year, strategists said in a weekly fixed income research note
- Comments from Fed Board of Governors member Lael Brainard indicated that Fed asset purchases could conclude before March. GSAM’s “position has benefited from recent hawkish Fed developments,” the strategists said
Quotable
“We are concerned that the impending taper of asset purchases and probable balance-sheet runoff, combined with rising net issuance of (agency) MBS, could result in an anomalous third straight year of negative excess returns for the MBS market as well, as MBS spreads historically have widened in response to quantitative tightening,” Bloomberg Intelligence analyst Erica Adelberg said in a Wednesday research note
What’s Next
ABS transactions in the queue for next week include Planet Fitness (whole business ABS), Servpro Industries (whole business ABS), and LendingPoint (consumer loan)
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