CLOs Continue to Recover Despite Challenging Fundamentals

June 18, 2020

Source: Bloomberg, Morgan Stanley Source: Bloomberg, Morgan Stanley

Collateralized loan obligation (CLO) performance continues to recover against a backdrop of challenging fundamentals. May’s CLO Index return of 4.0% represented the second month of recovery since the March sell-off. According to the LSTA Leveraged Loan Index, the price of leveraged loans has touched 90 cents for the first time since March. This has helped CLOs retrace about 70-80% of the previous widening, and on a year-to-date basis, CLOs (-2.1%) have outperformed U.S. high yield (-7.0%).

Credit markets (supported by the Federal Reserve’s expanded corporate bond purchase activity) are signaling the coronavirus pandemic is more of a short-term problem, despite CLO collateral quality continuing to deteriorate since March. Moody’s has downgraded $7 billion of loans and S&P has downgraded $5 billion. COVID-19-impacted companies are the main driver of fundamental weakness, due to the uncertainty surrounding the severity and duration of the pandemic. The wave of downgrades has put pressure on many deals, which are now failing key tests such as the junior overcollateralization test and the CCC concentration limit. However, we have seen some positive signals in the loan market, with CCC loan prices rallying slightly and downgrades tapering off since late April. CLO managers, in general, haven’t sold many of their CCC loans and, given the poor liquidity in the loan market, I don’t expect selling to accelerate anytime soon.

Additionally, selling at distressed prices could negatively impact certain CLO credit metrics, and the buyer base for CCC loans remains thin. However, once earnings start coming in over the next one to two quarters, downgrades may begin to pick up. That scenario could lead to a more challenging time for the leveraged loan market and lower-rated CLOs.

Key Takeaway

CLOs that are failing key tests could have their payments to equity and mezzanine tranches stopped, but senior bondholders could benefit from the resulting faster return of principal.  I continue to favor CLO managers that have shown resilience during the current crisis by choosing strong-balance-sheet companies and improving underlying CLO credit quality through active trading.

Tags: CLOs | Leveraged Loans | Credit markets | CLO managers | Coronavirus

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