Leveraged Loan Risk in CLOs

August 23, 2018

Leveraged Loan Risk in CLOs Photo

There has been a lot of press lately regarding potential risks in leveraged loans, what direction they may be headed and how this all impacts collateralized loan obligations (CLOs). A search for positive news coverage on CLOs doesn’t yield much, as investors still think back to the financial crisis and apply a ‘guilt by association’ approach to how they think about CLOs. This is partially due to the fact that CLOs are a distant cousin to other more egregious types of collateralized debt obligations (CDOs), which at one point became a kitchen sink of asset types and collateral quality. 

There are many ways to perform deep credit analysis on CLOs, but this week’s chart highlights a few of the more popular risk metrics employed in evaluating them. As seen in the chart, when CLO deals season, a slight deterioration in credit quality is expected, as the higher quality loans in the pool prepay sooner than the lower quality loans. The aforementioned factors lead to less diversity in the pool, a higher weighted average rating factor (WARF) and a higher concentration of securities rated CCC+ or lower. This dynamic is even more pronounced in the dwindling pre-crisis (1.0) CLO sector. However, the concentration of second lien loans remains rather stable as CLO deals season. This can be attributed to covenants in the deal documentation that govern and restrict the CLO issuers in their active management of these trusts. 

Active management is an integral benefit of CLOs compared to the leveraged loan market. A typical sophisticated CLO issuer has a sizable number of high yield credit analysts and a handful of very experienced portfolio managers capable of seeing risks in the current environment and able to predict potential risks on the horizon. Chances are, if media publications are waving red flags regarding the leveraged loan market, CLO issuers are already aware of these risks and may have already taken steps to mitigate them. CLO active management can help navigate certain risks that might be more difficult for the leveraged loan market to avoid. 

Key Takeaway

CLOs offer structural protections and active management to help protect against the risks inherent in the leveraged loan market. Some credit quality deterioration is expected as CLO deals season. However, active management can protect investors from this end-of-life deterioration in CLOs.  Sophisticated CLO issuers are typically well-equipped to navigate the current risks in the leveraged loan market and to potentially foresee new risks on the horizon. 

Tags: Collateralized Loan Obligation (CLO) | Active management

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